Complexity Considerations and Market Behavior

The article is concerned with market behavior when firms have limited ability to handle effectively the complexity of changing market conditions and strategic interaction . Modelling the managerial bounded rationality by using the concept of strategic complexity as measured by a finite automation, we show that market behavior can be considerably altered once there is a limit on the complexity of strategies. In particular, we demonstrate that when an incumbent firm operates in several markets, an entry to one market may induce the incumbent to exit from another market (divestiture) in order to "concentrate" on the competition it faces. For different parameters the incumbent may react to such an entry by exit from the same market, creating specialization. We also demonstrate that bounded complexity can serve as an entry barrier, giving an advantage to the established incumbent firm.

[1]  A. Rubinstein,et al.  The Structure of Nash Equilibrium in Repeated Games with Finite Automata (Now published in Econometrica, 56 (1988), pp.1259-1282.) , 1986 .

[2]  James Dow,et al.  Search Decisions with Limited Memory , 1991 .

[3]  J. Mirrlees.  The Optimal Structure of Incentives and Authority Within an Organization , 1976 .

[4]  Paul R. Milgrom,et al.  A theory of hierarchies based on limited managerial attention , 1991 .

[5]  A. Rubinstein.  Finite automata play the repeated prisoner's dilemma , 1986 .

[6]  Paul Milgrom,et al.  Bargaining and Influence Costs and the Organization of Economic Activity , 1987 .

[7]  E. Kalai,et al.  Finite Rationality and Interpersonal Complexity in Repeated Games , 1988 .

[8]  R. Aumann.  Survey of Repeated Games , 1981 .

[9]  Sherwin Rosen,et al.  Authority, Control, and the Distribution of Earnings , 1982 .

[10]  Itzhak Gilboa,et al.  Bounded Versus Unbounded Rationality: The Tyranny of the Weak , 1989 .

[11]  R. Coase.  The Nature of the Firm , 1937 .

[12]  E. Kalai.  Bounded Rationality and Strategic Complexity in Repeated Games , 1987 .

[13]  A. Neyman.  Bounded complexity justifies cooperation in the finitely repeated prisoners' dilemma , 1985 .

[14]  Roger Guesnerie,et al.  Increasing Returns to Size and their Limits , 1988 .

[15]  N. Kaldor,et al.  The Equilibrium of the Firm , 1934 .

[16]  R. Selten.  The chain store paradox , 1978 .

[17]  T. Ichiishi,et al.  Game Theory and Applications , 1990 .

[18]  Paul R. Milgrom,et al.  Employment Contracts, Influence Activities, and Efficient Organization Design , 1987, Journal of Political Economy.

[19]  O. Williamson.  Hierarchical Control and Optimum Firm Size , 1967, Journal of Political Economy.

[20]  Paul Milgrom,et al.  An Economic Approach to Influence Activities in Organizations , 1988, American Journal of Sociology.

[21]  H. Simon,et al.  On How to Decide What to Do , 1978 .