IO: Theory eJournal | 2019
Rational Inattention as an Empirical Framework: Application to the Welfare Effects of New Product Introduction
Abstract
In the conventional economic models of discrete choice where consumers are fully informed about choice alternatives, consumer-welfare increases whenever more alternatives are added to the choice set. However, endowed with subjective prior beliefs over choice alternatives, consumers often end up acquiring only incomplete information about the alternatives. Under the presence of incomplete information over alternatives, a new alternative added to the choice set may either improve or reduce the chance of consumers choosing the best alternative. Then it becomes an empirical question whether the actual consumer welfare rises or falls when more products are added to the set of alternatives. To address the question, this paper develops a novel empirical framework of discrete-choice and consumer-welfare evaluation wherein increasing variety does not mechanically predict higher consumer-welfare. The empirical framework incorporates consumers subjective prior belief to Rational Inattention (RI) theory by Matĕjka and MacKay (2015); Fosgerau et al. (Forthcoming), accounting for the role of both consumers subjective prior belief and incomplete information acquisition over alternatives. The framework developed is applied to a case of the consumer-welfare effects from the introduction of the new Tide Pods products into the laundry detergent market in 2012. The proposed empirical framework suggests Tide Pods entry reduced consumer-welfare on average. A counterfactual pricing experiment suggests a 6%-7% price cut of Tide Pods will make an average consumer just as well off as prior to Tide Pods entry.