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...imal for the high types. 26 Both s and s occur with positive probability. 21 If prices and qualities were endogenous, the considerations of price discrimination (Michael Mussa and Sherwin Rosen 1978; =-=Tirole 1988-=-, ch. 3) would substantially complicate the model in a direction orthogonal to the topic of this paper. 22 The multiplicative functional form is of no consequence and is utilized merely for ease of ex...

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...le only 1.65% of those in the extensive-selection 31 “The Compromise Effect,” Washington Post, January 27, 2002. 32 A notable exception arises if agents have self-control problems (e.g., Strotz 1955; =-=Laibson 1997-=-; Gul and Pesendorfer 2001). I abstract from these issues. 33 The idea that excessive choice is potentially undesirable has been emphasized in the popular press as well. For a recent example, see “One...

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...cher set, its choices would reveal too much information to the uninformed. Additionally, the considerations of price discrimination with endogenous qualities would substantially complicate the model (=-=Mussa and Rosen 1978-=-; Tirole 1988, Chapter 3; Anderson and Dana 2005) 14where M is the set of varieties the firm offers, Dj( −→ p,s) is the demand for variety xj given all the prices and the preference parameter s, and ...

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...ral (Hotelling 1929; Chamberlin 1951; Spence 1976) and on the influence of asymmetric information on market structure in particular. Much of the latter literature focuses either on adverse selection (=-=Akerlof 1970-=-) or on the role of signalling in a setting with repeat purchases (Nelson 1974; Schmalensee 1978; Milgrom and Roberts 1986). The analysis in this paper considers neither of these issues but rather exa...

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...ices is independent of s, so Assumption P does not place any restrictions on off-equilibrium beliefs. The solution concept is Perfect Bayesian Equilibrium with the D1 criterion (Banks and Sobel 1987; =-=Cho and Kreps 1987-=-). The D1 criterion is an equilibrium refinement widely used in signalling games. It strengthens the “Intuitive Criterion” of Cho and Kreps (1987): it requires that if the set 9 Matthew Rabin and his ...

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...l inference may not be the complete story in some examples of context effects, 5 and certain demonstrations of anchoring reveal a framing effect in a setting where information should not play a role (=-=Tversky and Kahneman 1974-=-; Ariely, Loewenstein, and Prelec 2003). In these anchoring experiments, the authors attempt to make it transparent to the subjects that the anchor has no informational value. However, it may be that ...

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...metric information on market structure in particular. Much of the latter literature focuses either on adverse selection (Akerlof 1970) or on the role of signalling in a setting with repeat purchases (=-=Nelson 1974-=-; Schmalensee 1978; Milgrom and Roberts 1986). The analysis in this paper considers neither of these issues but rather examines the impact of the informational content of product lines in a static sit...

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...ructure in particular. Much of the latter literature focuses either on adverse selection (Akerlof 1970) or on the role of signalling in a setting with repeat purchases (Nelson 1974; Schmalensee 1978; =-=Milgrom and Roberts 1986-=-). The analysis in this paper considers neither of these issues but rather examines the impact of the informational content of product lines in a static situation. The well-known insight that informed...

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...Even more telling of the importance bestowed on the compromise effect is its didactic use in books such as 101 Ways to Increase Sales (Van Eetvelde, Geens, and Harrington 2002) and Information Rules (=-=Shapiro and Varian 1999-=-). Other anomalous behaviors related to the compromise effect include choice overload and default effects. In choice overload experiments (e.g., Iyengar and Lepper 2000), customers are less likely to ...

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...market setting and analyze the supply side response to consumers’ contextual inference. The results in this paper also build on the industrial organization literature on product selection in general (=-=Hotelling 1929-=-; Chamberlin 1951; Spence 1976) and on the influence of asymmetric information on market structure in particular. Much of the latter literature focuses either on adverse selection (Akerlof 1970) or on...

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...monson (1989). This malleability of behavior is usually presented as evidence against stability of preferences andasaninvitationtoconsideralternative,psychologically richer, theories of choice (e.g., =-=Slovic 1995-=-). However, a simple recognition that contexts and frames may contain information suffices to reconcile these apparent anomalies with standard utility-maximizing behavior. In this paper, I 3develop a...

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... depends on the presence of other options. An extensive literature demonstrates context effects in laboratory settings. One of the most widely studied context effects is the compromise effect (Itamar =-=Simonson 1989-=-), 1 which refers to the finding that people tend to choose the middle option. More precisely, when three alternatives are available, the middle alternative is chosen more often than when it is paired...

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...rion” of Cho and Kreps (1987): it requires that if the set 9 Matthew Rabin and his colleagues have developed several tractable formalizations of mistaken inference (Eyster and Rabin 2005; Rabin 2002; =-=Rabin and Schrag 1999-=-). The cursed equilibrium model (Eyster and Rabin 2005), in particular, could be relevant to this setting. However, I utilize a standard equilibrium notion to demonstrate that my results do not requir...

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...in types of goods (e.g., books or music). The most common alternative hypothesis that attempts to explain choice overload argues that cognitive costs reduce the desirability of excessive choice sets (=-=Huffman and Kahn 1998-=-; Cristol and Sealey 2000; Gourville and Soman forthcoming). Most treatments of this hypothesis, however, seem not to recognize that the consumer can always randomly select a “small choice set” out of...

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...pport of the retail prices is independent of s, so Assumption P does not place any restrictions on off-equilibrium beliefs. The solution concept is Perfect Bayesian Equilibrium with the D1 criterion (=-=Banks and Sobel 1987-=-; Cho and Kreps 1987). The D1 criterion is an equilibrium refinement widely used in signalling games. It strengthens the “Intuitive Criterion” of Cho and Kreps (1987): it requires that if the set 9 Ma...

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...n. As an example, Figure 1 shows the compromise effect obtained by Simonson (1989). This tendency to avoid extreme options has been credited with affecting phenomena ranging from the demand for wine (=-=McFadden 1999-=-) to voting (Herne 1997) and investing (Benartzi and Thaler 2002). Even more telling of the importance bestowed on the compromise effect is its didactic use in books such as 101 Ways to Increase Sales...

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...boratory evidence suggests people make systematic mistakes in their inferences. In particular, the cursed equilibrium model (Eyster and Rabin 2005) or the analogy-based expectation equilibrium model (=-=Jehiel 2005-=-) could be relevant in this setting. Additionally, experimental evidence suggests that, apart from their mistakes in inference, many people exhibit limited strategic sophistication: they do not take...

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...anisms. 50 Another proposed explanation of choice overload argues that presence of more goods can increase decision conflict and thus reduce consumers’ willingness to select any of the goods offered (=-=Tversky and Shafir 1992-=-). 51 See Ben Irons and Cameron Hepburn (2007) and Todd Sarver (2008) for treatments of choice overload under regret.VOL. 98 NO. 5 kamenica: Contextual Inference in Markets 2141 the demand by the uni...

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...pply side response to consumers’ contextual inference. The results in this paper also build on the industrial organization literature on product selection in general (Hotelling 1929; Chamberlin 1951; =-=Spence 1976-=-) and on the influence of asymmetric information on market structure in particular. Much of the latter literature focuses either on adverse selection (Akerlof 1970) or on the role of signalling in a s...

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...ation on market structure in particular. Much of the latter literature focuses either on adverse selection (Akerlof 1970) or on the role of signalling in a setting with repeat purchases (Nelson 1974; =-=Schmalensee 1978-=-; Milgrom and Roberts 1986). The analysis in this paper considers neither of these issues but rather examines the impact of the informational content of product lines in a static situation. The well-k...

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...onsumers who exhibit some particular behavioral anomaly (e.g., Stefano DellaVigna and Ulrike Malmendier 2004; Paul Heidhues and Botond Kőszegi 2005, forthcoming; Xavier Gabaix and David Laibson 2006; =-=Spiegler 2006-=-; Kfir Eliaz and Spiegler 2007). In contrast to this line of research, I derive nonclassical behavior as a phenomenon that arises under standard preferences. In that vein, the choice overload section ...

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...interpretable quality dimension, i.e., the CD capacity, plays the role of the price. 25 Uncertainty about s canalsobeusedtointerpretresultsonscopeneglect (e.g., Kahneman 1986; Desvousges et al. 1992; =-=McFadden and Leonard 1993-=-; Frederick and Fischhoff 1998), and the experiments on “travelling indifference curves” (Drolet, Simonson, and Tversky 2000). 193.2 Premium Loss Leaders: Firm’s Manipulation of Consumers’ Beliefs I ...

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...uitive Criterion” of Cho and Kreps (1987): it requires that if the set 9 Matthew Rabin and his colleagues have developed several tractable formalizations of mistaken inference (Eyster and Rabin 2005; =-=Rabin 2002-=-; Rabin and Schrag 1999). The cursed equilibrium model (Eyster and Rabin 2005), in particular, could be relevant to this setting. However, I utilize a standard equilibrium notion to demonstrate that m...

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...monstrations of preference for smaller choice sets include Tversky and Sha…r (1992), Redelmeier and Sha…r (1995), 40A notable exception arises if agents have self-control problems (e.g., Strotz 1955; =-=Laibson 1997-=-; Gul and Pesendorfer 2001). I abstract from these issues. 41The idea that excessive choice is potentially undesirable has been emphasized in the popular press as well. For a recent example, see One ...

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...ties are quite 30similar to the preference externalities that arise when the prevalence of a particular taste induces a product line that provides less surplus for consumers with less common tastes (=-=Waldfogel 2003-=-; George and Waldfogel 2003). Because of these externalities, the consumers would wish to sort into separate stores for the informed and the uninformed. This desire for sorting may be an important fac...

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...uality. The more easily interpretable quality dimension, i.e., the CD capacity, plays the role of the price. 25 Uncertainty about s canalsobeusedtointerpretresultsonscopeneglect (e.g., Kahneman 1986; =-=Desvousges et al. 1992-=-; McFadden and Leonard 1993; Frederick and Fischhoff 1998), and the experiments on “travelling indifference curves” (Drolet, Simonson, and Tversky 2000). 193.2 Premium Loss Leaders: Firm’s Manipulati...

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...sion, i.e., the CD capacity, plays the role of the price. 25 Uncertainty about s canalsobeusedtointerpretresultsonscopeneglect (e.g., Kahneman 1986; Desvousges et al. 1992; McFadden and Leonard 1993; =-=Frederick and Fischhoff 1998-=-), and the experiments on “travelling indifference curves” (Drolet, Simonson, and Tversky 2000). 193.2 Premium Loss Leaders: Firm’s Manipulation of Consumers’ Beliefs I now examine a setting with a p...

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...duct lines in a static situation. The well-known insight that informed consumers can exert a positive externality on the uninformed ones (Wolinsky 1983; Salop and Stiglitz 1977; Chan and Leland 1982; =-=Cooper and Ross 1985-=-) plays a central role in the analysis of the compromise effect in Section 3. However, Section 4 reveals a limitation of this intuition and establishes that in the situations with choice overload, uni...

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... shows the compromise effect obtained by Simonson (1989). This tendency to avoid extreme options has been credited with affecting phenomena ranging from the demand for wine (McFadden 1999) to voting (=-=Herne 1997-=-) and investing (Benartzi and Thaler 2002). Even more telling of the importance bestowed on the compromise effect is its didactic use in books such as 101 Ways to Increase Sales (Van Eetvelde, Geens, ...

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...would reveal too much information to the uninformed. Additionally, the considerations of price discrimination with endogenous qualities would substantially complicate the model (Mussa and Rosen 1978; =-=Tirole 1988-=-, Chapter 3; Anderson and Dana 2005) 14where M is the set of varieties the firm offers, Dj( −→ p,s) is the demand for variety xj given all the prices and the preference parameter s, and the expectati...

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...mperfectly competitive industries, optimal prices of different varieties are generally distinct due to differences in demand, yet firms often provide many differentiated products at identical prices (=-=McMillan 2005-=-). For example, branded T-shirts of different colors, while they differ greatly in popularity, typically sell at same price. Homogeneous prices are common in a variety of industries, from yogurts to m...

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... costs. I assume that prices are exogenous. This assumption greatly simpli…es the exposition and increases the transparency of the mechanisms that drive the results. An earlier version of this paper (=-=Kamenica 2006-=-) derives the results in a setting with endogenous prices.13 Thesrms strategy may depend on s, so the uninformed consumers rationally update their beliefs about s based on thesrms behavior, forming ...

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...o-dimensional quality. The more easily interpretable quality dimension, i.e., the CD capacity, plays the role of the price. 25 Uncertainty about s canalsobeusedtointerpretresultsonscopeneglect (e.g., =-=Kahneman 1986-=-; Desvousges et al. 1992; McFadden and Leonard 1993; Frederick and Fischhoff 1998), and the experiments on “travelling indifference curves” (Drolet, Simonson, and Tversky 2000). 193.2 Premium Loss Le...

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...y one other option. Figure 1 shows the compromise e¤ect obtained by Simonson (1989). This tendency to avoid extreme options has been credited with a¤ecting phenomena ranging from the demand for wine (=-=McFadden 1999-=-) to voting (Herne 1997) and investing (Benartzi and Thaler 2002). Even more telling of the importance bestowed on the compromise e¤ect is its didactic use in books such as 101 Ways to Increase Sales ...

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...ational content of product lines in a static situation. The well-known insight that informed consumers can exert a positive externality on the uninformed ones (Wolinsky 1983; Salop and Stiglitz 1977; =-=Chan and Leland 1982-=-; Cooper and Ross 1985) plays a central role in the analysis of the compromise effect in Section 3. However, Section 4 reveals a limitation of this intuition and establishes that in the situations wit...

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...inction additionally illuminates other behavioral anomalies. Consider the research on joint-separate evaluation preference reversals (e.g., Bazerman, Loewenstein and White 1992; Bazerman et al. 1994; =-=Lowenthal 1993-=-). A joint-separate evaluation preference reversal obtains when an option (A) is generally preferred to its alternative (B) if each is presented separately 22 This holds in the particular model I have...