Abstract

Context can influence decisions. This malleability of choice is usually invoked as evidence that people do not maximize stable preference orderings. In a market equilibrium, however, context conveys payoff-relevant information to consumers. Consequently, these consumers rationally violate naïve formulations of standard choice theoretic principles. I identify informational asymmetries under which apparently anomalous behaviors, namely the compromise effect and choice overload, arise as market equilibria. Firms respond to consumers’ contextual inference; in case of the compromise effect, a firm may introduce premium loss leaders (expensive goods of overly high quality that increase the demand for other goods). (JEL D11, D83, M31) Numerous studies demonstrate that seemingly irrelevant factors influence people’s decisions. Perhaps the best known examples of such influence are context effects. A consumer exhibits a context effect if her choice between two alternatives systematically depends on the presence of other options. An extensive literature demonstrates context effects in laboratory settings. One of the most widely studied context effects is the compromise effect (Itamar Simonson 1989), 1 which refers to the finding that people tend to choose the middle option. More precisely, when three alternatives are available, the middle alternative is chosen more often than when it is paired with only one other option. Figure 1 shows the compromise effect obtained by Simonson (1989). This tendency to avoid extreme options has been credited with affecting decisions ranging from the demand for wine (Daniel L. McFadden 1999) to voting (Kaisa Herne 1997) and investing (Shlomo Benartzi and Richard H. Thaler 2002). Even more telling of the importance bestowed on the compromise effect is its didactic use in books such as 101 Ways to Increase Sales (Dirk

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