Price competition and cost efficiency facing buyer’s bounded rationality

This paper studies a pricing game in which two sellers compete to sell a product to a customer with bounded rationality. The sellers have different production costs in determining their respective prices to offer to the buyer. The buyer prefers the seller offering a lower price, but may suffer from some behavioral noises, such as bias, peer pressure and incapability, that lead the buyer to choose the seller offering a higher price with certain probability. In this sense, the buyer’s choice under bounded rationality is characterized in a probabilistic model. We find that if the buyer is mildly affected by bounded rationality, the seller with a lower production cost will lower the price to increase the probability to be chosen, but will increase the price for a better profit margin as the bounded rationality level increases. On the contrary, the seller with a higher production cost always enhances the price facing the buyer’s bounded rationality. Buyer’s bounded rationality is a driving factor for sellers’ price dispersion. Interestingly, we show that the bounded rationality, traditionally viewed as a performance-degrading impediment, may potentially lead to an unexpectedly higher payoff for the buyer. However, buyer’s bounded rationality is always detrimental to the social welfare as a whole. We also extend the results to the case with multiple sellers and show that the sellers will ask for even lower prices when the buyer has an outside option.