Incorporating Behavioral Anomalies in Strategic Models

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Incorporating Behavioral Anomalies in Strategic Models CHAKRAVARTHI NARASIMHAN Washington University in St. Louis

[email protected]

CHUAN HE University of Colorado, Boulder ERIC T. ANDERSON Northwestern University LYLE BRENNER University of Florida PREYAS DESAI Duke University DMITRI KUKSOV Washington University in St. Louis PAUL MESSINGER University of Alberta SRIDHAR MOORTHY University of Toronto JOSEPH NUNES University of Southern California YUVAL ROTTENSTREICH RICHARD STAELIN Duke University GEORGE WU University of Chicago Z. JOHN ZHANG University of Pennsylvania

Abstract Behavioral decision researchers have documented a number of anomalies that seem to run counter to established theories of consumer behavior from microeconomics that are often at the core of analytical models in marketing. A natural question therefore is how equilibrium behavior and strategies would change if models were to incorporate these anomalies in a consistent way. In this paper we identify several important and generalizable anomalies that modelers may want to incorporate in their models. We briefly discuss each phenomenon, identify a key unresolved issue and outline a research agenda to be pursued.

362 Keywords:

NARASIMHAN ET AL.

marketing strategy, game theory, reference dependence, fairness, confirmatory bias

Introduction Strategic models in marketing focus on predicting/explaining firms’ strategies given the reactions of customers and competitors. In these models, modelers prescribe the preferences, objective functions, and the constraints the players face as well as the rules of the game they play. These fundamental building blocks are almost always based on the microeconomic theory of consumer and firm behavior, with the equilibrium strategies determined using the standard solution procedures of game theory. The standard assumptions are that agents (firms and customers) have well defined preferences over the outcomes that are based on the choices they make, and that they act in their self interest maximizing their own welfare subject to the constraints they face. The seminal articles of Kahneman and Tversky (1979), Tversky and Kahneman (1974, 1991) have advanced an alternative theory to the microeconomic foundations of consumer behavior, and in turn, consumer behavior researchers have documented a variety of deviations from classical utility maximizing behavior. These deviations, which we refer to as anomalies, have been demonstrated in laboratory experiments as well as in field studies. Yet, little is known about the effect of these anomalies on firms’ strategies, both in a positive sense—whether their behavior already reflects these anomalies—and in a normative sense, whether they ought to. The literature that incorporates behavioral considerations in strategic models is a small one. In this paper, we consider three anomalies that have the promise of improving the insights from marketing models: reference dependence, fairness, and confirmatory bias. We review extant analytic models that have incorporated these behaviors