Unshrouding for Competitive Advantage

• Date: 01 September 2013
• Author: Carsten Dahremöller
• DOI: http://doi.org/10.1111/jems.12025
• Published date: 01 September 2013

Unshrouding for Competitive Advantage

CARSTEN DAHREM ¨

OLLER

Bonn Graduate School of Economics

University of Bonn, Kaiserstrasse 1,

53113 Bonn, Germany

dahremoeller@gmail.com

In a market with hidden product details and systematic consumer biases, firms have the possibility

to unshroud and thereby to rectify such market obliquities. While the classical view was that firms

will have an incentive to unshroud, Gabaix and Laibson (2006) show that there exist constellations

in which firms prefer to leave the market shrouded. Building on that model I introduce a more

strategic and long-term dimension of unshrouding which turns out to fundamentally alter

the underlying incentives to unshroud. In particular, I show that there exists an incentive to

unshroud that stems from differences in add-on profitabilityand that it is dependent on parameter

constellations whether a more profitable or a less profitable firm will want to unshroud.

1. Introduction

Consumers in many markets have difficulties making rational decisions or face barriers

when trying to collect all information that is relevant for their consumption choice. In

these markets firms might either foster or alleviate such market obliquities. For example,

in the case of retail financial markets, Liebman and Zeckhauser (2004) identify an ar-

ray of contract characteristics that can influence the information reception of consumers.

Among them are nonlinear pricing, schedule complexity, frequent revisionsof schedules,

complex vocabulary, delayed costs or bundled consumption. By employing or refrain-

ing from these contract characteristics firms are able to manipulate the perceptions of

consumers.

In the following, I propose a model of such markets in which the degree of con-

sumer sophistication can be manipulated by the competing firms. My model is inspired

by the seminal work of Gabaix and Laibson (2006) (henceforth GL), who model an add-

on market with hidden add-on prices and limited consumer attention. Firms set prices

for their base goods and add-ons and have the option to unshroud the add-on. In their

model, both the pricing and the unshrouding decisions are taken simultaneously. If any

firm decides to unshroud, all add-on prices get revealed and a part of the consumer

population gets educated. Building on this model GL show that, for certain parameter

constellations, equilibria exist in which none of the firms unshrouds the add-on.

In the following, I will enrich the model of GL by assuming that firms are het-

erogeneous in their add-on profitability and, more importantly, by applying a different

modeling of consumer education. In particular, I will assume that firms can shroud or

In preparingthis paper I have greatly benefited from comments made by two anonymous referees, Markus Fels,

Paul Heidhues, Fabian Herweg, and Matthias Kr¨

akel. I also thank seminar audiences in Bonn and participants

at the Nordic Behavioral Conference 2010 in Helsinki, the IO Workshop 2010 at the ESMT Berlin, and the

Behavioral Economics Workshop 2011 at the ESMT Berlin. All remaining errors are my own responsibility.

This work was supported by the Bonn Graduate School of Economics.

C2013 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume22, Number 3, Fall 2013, 551–568

552 Journal of Economics & Management Strategy

unshroud the add-on before they set their prices. This allows unshrouding to have more

long-term consequences than in the model of GL.

Using this framework I show that for almost all parameter constellations no shroud-

ing equilibrium exists. At least one firm has an incentive to unshroud the add-on in an

attempt to wreck the rival firm’s attempts at shrouding. By doing so, the unshrouding

firm can influence the shrouding firm’s profits within the add-on market and thereby

profitably soften competition in the base good market. This incentive to unshroud the

add-on is driven by the differences between the firms with regard to their add-on

profitability. Thereby it is dependent on parameter constellations whether it is the com-

paratively efficient firm or the comparatively inefficient firm that unshrouds the add-on.

Tomotivate my results, I first want to give some anecdotal evidence for the depicted

firm behavior, in particular for the prediction that there exist cases in which either an

efficient firm or an inefficient firm unshroudsthe add-on. An example of unshrouding by

an efficient firm could be Citibank if it advertises the convenience of its dense coverage

of branches. It is efficient because due to its size it has a large number of branches, and

due to its market share, it profits from its economies of scale and its per-customer costs

of providing local services are low.In contrast, smaller banks have higher cost and might

have to rely on cash points from other banks which is costly for its customers. If Citibank

would then advertise its dense branch and cash point coverage, this might induce

customers to take such features into account when making their purchase decision and

increase their likelihood to relocate their account to Citibank.

An example of unshrouding by an inefficient firm was the bank Barclays when it

introduced iShares, which are a collection of exchange traded funds that are passively

managed and track the value of certain underlying assets, for example the S&P 500. Such

investment vehicles are usually offered as supplementary services to bank account hold-

ers. On average, such passively managed funds perform better than actively managed

funds (Gruber, 1996), which were and still are a very popular investment vehicle. Bar-

clays, in contrast to other banks, did not make much profit from actively managed funds

due to a lack of scale. Although Barclays continued to offer actively managed funds after

the introduction of iShares, they launched an advertisement campaign emphasizing the

benefits of their new iShares product, but also pointing out disadvantages and negative

attributes of actively managed funds.1This can be seen as an attempt to sabotage the

market for actively managed funds. In other words, Barclays tried to acquit itself from

its comparative disadvantage by trying to dissolve the add-on market in which it is

inefficient.

The results of this paper also give an indication what markets are particularly

susceptible to shrouding. As said before, I show that at least one firm will unshroud the

add-on if unshrouding is costless. Evidently, in reality there might be costs associated

with unshrouding. For example, there might be costs of setting up an advertisement

campaign, costs of providing information to consumers, or costs for professionals which

customers can consult. Such costs make unshrouding less attractive. Now recall that

the incentive to unshroud is driven by the differences between the firms with regard

to their profitability in the add-on dimension. Therefore, unshrouding should be more

likely to be observed in markets in which firms have considerable differences in add-on

profitability while shrouding should be observed in markets with rather homogeneous

add-on profitability.

1. See Carrell (2008) for further details. The advertisement campaign reported the hidden costs, intrans-

parency,illiquidity, and comparatively low performance of actively managed funds.