The impact of information sharing opportunities on market outcomes: an experimental study.

• Author: Cason, Timothy N.

1. Introduction

   Information regarding uncertain demand conditions or industry costs, as well as the opportunity to share this information, can have an important impact on firm behavior. A series of recent game-theoretic models have characterized the incentives for firms to share information regarding uncertain parameters [3; 7; 8; 13; 14; 16; 22; 26; 20; 21 provide a comprehensive survey]. Most of the models assume that behavior in the output market is noncooperative, regardless of the firms' information sharing decisions. This paper reports a series of 15 laboratory sessions that test the noncooperative, backward induction approach of these models. The results suggest that pricing behavior may be influenced by the information sharing decision: Under most conditions the non-cooperative Nash model accurately describes average behavior, although in certain conditions information sharing appears to facilitate tacit collusion. The paper also estimates a simple behavioral model of learning that describes how experimental subjects learn the optimal information sharing decision as an alternative to the theories' backward induction assumption.

   The information sharing models tested here have been interpreted as identifying the incentives for competitive firms to form a trade association that reduces their uncertainty. Thousands of trade and professional associations are active worldwide, and the majority collect information from their members that is aggregated and distributed through association statistical programs. The theoretical models demonstrate how three variables influence the information sharing incentives: 1) The type of competition (Bertrand or Cournot); 2) the nature of the goods (substitutes or complements); and, 3) the source of uncertainty (demand or cost). The first two variables determine the slope of the firms' reaction functions, and the uncertainty source along with the information sharing decision determines the degree of correlation among the firms' strategies. The incentive for noncooperative firms to share information shifts as these three variables change because reduced correlation has a negative or positive effect on profit depending upon the slope of the reaction functions.

   The models usually have two stages. In the first stage, firms make a decision regarding the amount of private information they wish to truthfully reveal to other firms. This can be thought of, for example, as the establishment and funding decision of a trade association statistical program. This decision is made before any uncertainty is resolved. In the second stage, firms choose noncooperative output or price strategies based upon the information revealed in stage one. No additional firm interaction occurs after stage two. The equilibrium concept is Nash subgame perfection, so that the first-stage information sharing decision is optimal given the second-stage (subgame) equilibrium.

   The models typically identify unique dominant strategy information sharing equilibria assuming Nash competition in the second stage. Vives [26] shows that with an uncertain common demand intercept and quantity competition, firms' dominant strategy is to reveal (conceal) demand information if the goods are complements (substitutes). Vives also demonstrates that the incentives reverse with price competition so that firms should reveal (conceal) demand information if the goods are substitutes (complements). Gal-Or [8] shows that if costs are uncertain but are conditionally independent across firms, firms' dominant strategy is to reveal (conceal) cost information under quantity (price) competition if the goods are substitutes. Cason [2] demonstrates that with price competition and perfectly correlated but uncertain costs, firms' dominant strategy is to reveal (conceal) private cost information if the goods are complements (substitutes). The experiment reported here tests these qualitatively distinct dominant strategy predictions by using the uncertainty

   source and demand structure as treatment parameters.

   Antitrust authorities have been concerned for many years with the behavior of trade and professional associations.(1) One focus of this concern has been the publishing of information (such as prices) that may make a cooperative agreement easier to enforce. Clarke [4], in contrast, argues that information sharing can facilitate collusion because it eliminates disagreements based on private information and it homogenizes firms' perceptions. He concludes that "information-pooling mechanisms like trade associations can be considered prima facie evidence that firms are illegally cooperating to restrict output [4, 392]." Kirby [13], however, shows that in a model very similar to Clarke's, noncooperative firms will want to share information if cost functions are sufficiently quadratic. Kirby concludes that "Trade associations, therefore, are not prima facie evidence of collusion [13, 145]." Whether information sharing facilitates tacit collusion is an empirical question. The results presented here provide limited empirical support for the hypothesis that a relationship exists between information sharing and cooperative pricing behavior. In the sessions with cost uncertainty and complement goods, collusive behavior is observed when information is shared. However, in the demand uncertainty sessions and in all sessions with substitute goods, the noncooperative Nash model describes average price behavior more accurately.

   This static, two-stage model is the dominant approach employed in the extensive information sharing literature, although it does not capture fully the incentives for firms which interact repeatedly in the same industry. This limits the application of the available theoretical work for policy toward trade association activities. Nevertheless, the experiment implements a test of the existing static theory by randomly re-pairing subjects with new rivals each period. This is therefore a theory-testing experiment that evaluates this noncooperative, static approach on the theory's domain as much as possible. (See Smith [23, 940-942] for a methodological classification of experiments.) Future experiments can extend this test to include more realistic features of trade associations that are not present in existing theory (called boundary experiments), such as repeated interactions among the same sellers.

   We wish to emphasize that this experiment is not intended to test subjects' ability to solve strategic problems like game theorists. Like many models in industrial organization, the problem described in the next section is clearly too complicated for undergraduates (or, for that matter, firm managers) to solve without training in game theory. Instead, we are interested in testing if human decision-makers can develop heuristic mechanisms that lead them to eventually behave according to the predictions economists make using game-theoretic tools. The results provide support for the subgame perfect Nash equilibrium in this environment, and identify simple trial-and-error learning rules that lead to optimal behavior. Therefore, this research offers empirical support for a class of industrial organization models and the information-sharing literature in particular.(2)

2. The Model

   The model developed here and tested by the experiment is a simplified version of the demand uncertainty model from Vives [26] and the (perfectly correlated) cost uncertainty model from Cason [2]. (The model in Cason [2] is very similar to the model in Gal-Or [8]; the substantive difference is that Gal-Or's model assumes that the random costs are uncorrelated across firms, in contrast to the perfectly correlated costs in Cason's model.) Two major simplifications are required to operationalize the model in a form simple enough to be understood by the experimental subjects. First, the information structure is modified so that information quality is asymmetric; i.e., one firm has more accurate information. Second, the firm with high-quality information is given perfect information regarding the realization of the random variable.(3)

   The model contained here is representative of many of the information sharing models cited in the introduction. Among the shared features are the following: Firms make information sharing decisions before the realization of the random variables, output market competition is noncooperative, and the subgame perfect equilibria require firms to understand the implications of their first stage information sharing decision on output market profit. This operational model captures the essential features of the more complex theoretical models and yields testable predictions about the effects of uncertainty and information sharing opportunities on market outcomes.

   We develop the cost uncertainty and demand uncertainty versions of the model in parallel to highlight how firms have opposite information incentives in the two cases. In addition to making price predictions, the model implies that in a subgame perfect equilibrium, firms will share (conceal) cost information if the goods are complements (substitutes), and will conceal (share) demand information if the goods are complements (substitutes). Figure 1 summarizes this shifting information sharing result.

   Demand and Costs

   In this duopoly model, the two firms choose prices and each faces a linear demand curve given by

   [q.sub.i] = a - [bp.sub.i] + [dp.sub.j], i = 1, 2 and i [is not equal to] j (1)

   Assume that a, b [is greater than or equal to] 0 and that b [is greater than] [absolute value of] d. The latter assumption requires that "own-price" effects dominate "cross-price" effects. Clearly, the goods are substitutes if d [is greater than] 0 and are complements if d [is less than] 0. If d = 0, the goods are independent. Each firm faces the same constant unit costs c for each unit sold and production is made to order (i.e., there are no inventories).

   Uncertainty

   The source of uncertainty is...