Paternalism and the iPod, Part II: The Behavioral Economics of Apple?

Dave Hoffman over at Concurring Opinions asks: “Is Apple Exploiting Consumer Irrationality?” Dave is worried that consumers’ continuing iPod purchases may be irrational in the face of evidence that many iPod’s fail within their one year warranty period or shortly after, and that this strategy might explain Apple’s “growing market strength.” How likely are consumer biases to explain Apple’s success? In short, not very.

The claim seems to be that Apple’s product design decisions attempt to exploit consumers’ inability to realize that their iPod’s will break down sooner rather than later. Does this mean Apple could build a better iPod, but choose not to in order to increase its market share? Dave explains how the theory might work:

The optimism bias is among the most robust of the cognitive tics exposed by experimental behavioral law and economics literature. We consistently underestimate the likelihood of bad things happening to us. So, although Apple’s one-year warranty suggests a steep product failure curve at month 13, we discount that risk in our purchase decision.

Ahhh. The optimism bias. Two points here. First, I do not doubt that optimism bias is actually and meaningfully observed by some experiments, and is a real phenomenon on the individual level. As Jon Klick and Greg Mitchell point out, only a small number of subjects need exhibit a bias in order for it to achieve statistical significance. That said, the power of even the most robust of these findings, such as the “endowment effect,” have been (at the very least) called into question by recent research. I am quite skeptical that the optimism bias is a leading candidate for explaining Apple’s success.

Second, the question is, and always has been, what happens to individual biases in markets? Do markets serve as a “debiasing” force? Or do they exacerbate individual biases? If the second is correct, what are the efficiency costs of the bias? I understand that Dave was not addressing this issue in his post, but if it is true that these biases are allowing Apple to dominate the market, well … I have read enough behavioral economics-based paternalistic regulatory proposals to know what is coming next: how do we regulate fix it?

So, before we turn to that question, let’s sketch out some of the economics here.

As a building block, let’s think about how competitive suppliers of iPod-like machines would respond to the presence of such biases. To make it exciting, make some assumptions that strengthen the impact of the biases: (1) all consumers exhibit them; (2) education cannot ameliorate their effects (“once a bias, always a bias”); (3) sellers are aware of (1) and (2); and (4) consumers who buy one type of machine are “locked in” for repeat purchases.

Ok, so what happens in the competitive market for iPod-type machines when consumers do not have the ability to correctly “price” the durability of the machine (or the short length of the warranty)? Because each consumer is biased in this manner, the initial sale is extremely valuable to the seller since it increases the probability of future sales. But in a zero profit equilibrium, sellers (aware of these future, bias-induced sales) will compete away the supra-competitive return by offering consumers favorable terms. For example, lowering the price. Completely biased consumers still receive the benefit of competition because sellers compete for the right to sell to them and appropriate the profits associated with the bias. This is good for consumers.

But, the allegation here seems to be that this is not a competitive market. Rather, Apple is presumed to have power over the pricing of iPod-type machines. The economics change now because Apple does not live in a zero profit equilibrium — so NOW wouldn’t this theory of anticompetitive harm be viable? I dont think so. If Apple is a monopolist, it strikes me as implausible that they would collect their monopoly return through repeat purchases induced by having machines disappoint consumers by breaking down early.
Perhaps Apple is waiting patiently for the day when it will use its market dominance to abuse consumers? As one commenter to Dave’s post expresses this concern:

who knows when they might suddenly decide to leverage that dominance into an effort to force all iPod users to buy Macs? “Just buy a Mac desktop” was suggested to me more than once by the guys at the ironically named “Genius Bar” at my local Apple store.”

Wait. Even a monopolist is allowed to allow its salespeople to suggest that you buy their products. In the meantime, Apple is offering substantial benefits to consumers by improving its product and developing complements. If we are truly concerned about the risk of future anticompetitive harm, wouldn’t it be wise to allow consumers to receive those benefits until the risk materializes? We are not talking about the costly “unscrambling” of a merger that turns out to be anticompetitive.
Of course, if consumer irrationality was the culprit, one might wonder why competitors do not simply shed light on the short product life of the iPod. I also wonder how one might map irrational consumer behavior into meaningful policy predictions. For example, do consumers with optimism bias sanction iPod for supplying products they feel are defective? Or does their optimism persist? Dave notes that:

This optimism is no doubt enhanced by Apple’s careful packaging, which makes it look like they’ve taken a swiss-like level of care in their manufacturing process, and iPod’s high-price, which suggests quality . . ..

This analysis suggests that so long as Apple retains its brand – expensive, low-defect, attention to detail – it will continue to convince consumers to buy products with lower-than-expected lives.

If only market success (and a monopoly rate of return!) was as easy as a fancy gadget in shiny packaging that breaks down early and disappoints consumers. I am in the wrong profession. Interestingly, Dave notes he will continue to buy another iPod despite his awareness of consumer optimism bias. Perhaps Apple’s success is not driven by optimism bias after all?