The Fable of Entry: Bounded Rationality, Market Discipline, and Legal Policy

Authors

Avishalom Tor, Boston University School of Law

Abstract

Legal scholars have recently advanced a behavioral approach to the law and economics school of thought in an attempt to improve its external validity and predictive power. The hallmark of this new approach is the replacement of the perfectly rational actor with a "boundedly rational" decisionmaker who, apart from being affected by emotion and motivation, has only limited cognitive resources. To function effectively in a complex :world, boundedly rational individuals must rely on cognitive heuristics - simplifying mental shortcuts - that inevitably lead people to make some systematic decision errors; as a result, their behavior necessarily deviates from that predicted by rational actor models. In response, advocates of traditional law and economics have argued that boundedly rational behavior is of little significance for the analysis of economic activities in market environments, most notably because competitive pressures will discipline such behavior. According to this view, the boundedly rational will underperform and consequently fail and exit the market. Some cautious supporters of the behavioral approach have been quick to agree that bounded rationality is of limited importance for the analysis of market behaviors because of competitive discipline. In fact, even the most influential proponents of behavioral law and economics have found it necessary to state, "law is a domain where behavioral analysis would appear to be particularly promising in light of the fact that nonmarket behavior is frequently involved." This Article heartily agrees that behavioral insights are highly applicable to those numerous areas in the law addressing nonmarket behaviors. Questioning the accepted wisdom on market discipline, however, it argues that advocates of the behavioral approach have conceded too much too quickly. It shows in the context of new entry into industry that, although intense competition eliminates many boundedly rational actors, competitive forces inevitably select some other such actors for success. Consequently, and because of their very large numbers, boundedly rational actors become overrepresented, as a group, among the ranks of successful entrants. In other words, this Article does not argue against the existence of market discipline; instead, it highlights how competitive forces unexpectedly facilitate bounded rationality in the market. The profound role of boundedly rational action in markets therefore renders its understanding supremely important for the legal regulation of economic phenomena. A study of the competition for profitability and survival among new entrants into industry thus highlights the unique contribution a behaviorally informed approach stands to make to legal and economic scholarship writ large, while shedding new light on the important topic of entry competition specifically.

Recommended Citation

Avishalom Tor, The Fable of Entry: Bounded Rationality, Market Discipline, and Legal Policy, 101 Mich. L. Rev. 482 (2002).
Available at: https://repository.law.umich.edu/mlr/vol101/iss2/4