The fable of entry: bounded rationality, market discipline, and legal policy.

• Author: Tor, Avishalom

TABLE OF CONTENTS INTRODUCTION I. THE PUZZLES OF ENTRY A. The Assumption of Entrant Rationality: Empirical Findings vs. Economic Theory 1. The First Puzzle: The Prevalence of Negative Net Present Value Entry 2. The Second Puzzle: Entrant's Insensitivity to Predictors of Future Profitability 3. The Third Puzzle: An Inferior Average Performance of Startup Entrants B. Can the Rationality Assumption be Salvaged? 1. Maintaining the Rationality Assumption: Windows of Opportunity, Limited Information, and the Fruits of Learning 2. Modifying the Rationality Assumption: Maximizing Expected Utility with Negative Net Present Values II. A BEHAVIORAL ANALYSIS OF ENTRY DECISIONMAKING A. Solving the First Puzzle: The Processes of Entrants' Overconfidence 1. Optimistic Bias 2. The Desirability Bias and Related Phenomena 3. The Illusion of Control B. Solving the Second Puzzle: The Side Effects of Entrants' Overoptimism 1. Optimistic Bias 2. Desirability Biases 3. The Illusion of Control 4. Underestimating the Importance of Indirect Effects in Competitive Settings C. Solving the Third Puzzle: All Entry is Not the Same 1. The Intensity of Preferences 2. Judgmental Ambiguity III. THE CONSEQUENCES OF ENTRANT-BOUNDED RATIONALITY A. How the Bounded Rationality of Entrants Transforms the Competitive Landscape B. The Limited Efficacy of Financier Gate Keeping C. The Consequences of Boundedly Rational Innovative Entry 1. Bounded Rationality and Innovative Entry 2. The Consequences of Innovative Entry IV. EVALUATING ENTRY AFRESH A. The Social Costs and Benefits of Boundedly Rational Entry B. Regulating Negative Expected Value Entry? C. Antitrust Law and Boundedly Rational Entry 1. General Conclusions: Entry and Market Power in Antitrust 2. Predatory Pricing: Entry and Recoupment 3. Horizontal Mergers: Entry in the Merger Guidelines V. BOUNDED RATIONALITY IN MARKETS: LESSONS FOR LEGAL POLICY A. The Prevalence of Bounded Rationality in Legally Relevant Market Settings B. The Limits of Arguments Relying on Markets to Eliminate Bounded Rationality C. Some Broadeer Lessons for Legal Analyses of Market Behavior 1. When Should Legal Analyses of Market Behavior Take Bounded Rationality into Account? 2. How Should Legal Analyses of Market Behavior Take Bounded Rationality into Account? CONCLUSION INTRODUCTION

Legal scholars have recently advanced a behavioral approach to the law and economics school of thought in an attempt to improve its external validity and predictive power. (1) The hallmark of this new approach is the replacement of the perfectly rational actor with a "boundedly rational" decisionmaker who, apart from being affected by emotion and motivation, has only limited cognitive resources. (2) To function effectively in a complex world, boundedly rational individuals must rely on cognitive heuristics--simplifying mental shortcuts--that inevitably lead people to make some systematic decision errors; as a result, their behavior necessarily deviates from that predicted by rational actor models. (3)

In response, advocates of traditional law and economics have argued that boundedly rational behavior is of little significance for the analysis of economic activities in market environments, most notably because competitive pressures will discipline such behavior. According to this view, the boundedly rational will underperform and consequently fail and exit the market. (4) Some cautious supporters of the behavioral approach have been quick to agree that bounded rationality is of limited importance for the analysis of market behaviors because of competitive discipline. (5) In fact, even the most influential proponents of behavioral law and economics have found it necessary to state, "law is a domain where behavioral analysis would appear to be particularly promising in light of the fact that nonmarket behavior is frequently involved." (6)

This Article heartily agrees that behavioral insights are highly applicable to those numerous areas in the law addressing nonmarket behaviors. Questioning the accepted wisdom on market discipline, however, it argues that advocates of the behavioral approach have conceded too much too quickly. It shows in the context of new entry into industry that, although intense competition eliminates many boundedly rational actors, competitive forces inevitably select some other such actors for success. Consequently, and because of their very large numbers, boundedly rational actors become overrepresented, as a group, among the ranks of successful entrants. In other words, this Article does not argue against the existence of market discipline; instead, it highlights how competitive forces unexpectedly facilitate bounded rationality in the market. The profound role of boundedly rational action in markets therefore renders its understanding supremely important for the legal regulation of economic phenomena. A study of the competition for profitability and survival among new entrants into industry thus highlights the unique contribution a behaviorally informed approach stands to make to legal and economic scholarship writ large, while shedding new light on the important topic of entry competition specifically.

New entry into industry has been a major topic of analysis in both legal and nonlegal literatures. (7) This Article offers a behavioral analysis of entrant decisionmaking that explains many empirical findings about entry that appear highly puzzling and seemingly unrelated from a traditional economic perspective. Part I describes these phenomena, which include the prevalence of excess entry, the relative insensitivity of entrants to market predictors of success, and the inferior performance of startup entrants as compared to those who enter by diversification. This Article reveals how these phenomena all result from the operation of the various processes of entrant overconfidence. (8)

On the most basic level, the processes of overconfidence--most notably, optimistic and desirability-related biases--explain the puzzling empirical phenomenon of excess entry, wherein the high rate of entry appears economically inexplicable in the face of its low expected value. (9) This conclusion is the main theme of an important recent experimental study in the nonlegal literature of the relationship between overoptimism and excess entry. (10)

Notwithstanding the findings of this leading study, the literature on entry, both legal and nonlegal, has thus far failed to examine whether, beyond revealing the basic fact of excess entry, the empirical data corroborate or contradict the claim of entrant overconfidence. By engaging in a closer analysis of both the economics and the psychology of entry, this Article breaks new ground in two important ways. First, it links additional puzzling empirical findings--such as entrants' relative insensitivity to entry barriers and other market predictors of success and, most importantly, the lower survival rates and inferior average performance of startups as compared to diversifying entrants--to the same psychological processes of entrant overconfidence that explain the basic fact of excess entry. Second, it provides a unified framework for a new understanding of the various aspects of entry decisionmaking, its economic consequences, and its implications for legal policy.

Part II shows how, from a behavioral perspective, deciding whether to attempt new entry is, first and foremost, an investment decision with significant personal stakes that must be made under conditions of extreme uncertainty. In these circumstances, entrants are likely to be overconfident in their prospects, thereby making excessive entry attempts. Moreover, the behavioral analysis of entry shows that entrants' insensitivity to pale, if potentially important, background market, whose impact on their fate is statistical and indirect, is a likely by-product of many of the processes of entrant overconfidence. A close analysis of these processes also exposes important and hitherto unnoticed behavioral differences between startups and diversifying entrants, differences that closely follow the economic differences between these two entrant types. The effects of two important psychological variables determining the extent of entrant overconfidence--the intensity of preferences and the ambiguity of the decision environment--are likely to cause startup entrants to exhibit a greater bias than diversifying ones. This novel finding explains the perplexing inferior average performance of startups.

Part III reveals that the same competitive pressures that weed out many overconfident entrants also generate a post-entry landscape in which the more extremely biased startups are over-represented, at the expense of some of their less-biased, ex ante better-qualified, competitors. After exploring why the private action of financiers fails to curb entrant overconfidence significantly, this Part considers the desirability and possibility of government intervention.

In Part IV, a careful study of the social costs and benefits of boundedly rational entry and the possibility of implementing an effective policy on this matter reveals, however, that the governmental regulation of entry is probably undesirable. An effort to regulate boundedly rational entry is impractical because of the difficulty of identifying negative expected value entry, determining when exactly to limit it at the margin, and finding an effective means of actually doing so. This Article finds, moreover, that although overconfident entrants generate social and private losses, they also fulfill an important economic function, serving as the voluntary cannon fodder of innovation. These entrants, even when they fail and more so when they succeed, facilitate economic growth and expand the range of consumer choice. Equally important, they make a significant long-term contribution to the disciplining of incumbent firms.

This analysis also has important implications for antitrust...