Market design with endogenous preferences

This paper explores the interdependence between market structure and an important class of extra-rational cognitive biases. Starting with a familiar bilateral monopoly framework, we characterize the endogenous emergence of preference distortions during bargainging which cause negotiators to perceive their private valuations differently than they would outside the adversarial negotiation context. Using this model, we then demonstrate how a number of external interventions in the structure and/or organization of market interactions (occuring before trade, after trade, or during negotiations themselves) can profoundly alter the nature of these dispositions. Our results demonstrate that many such interventions frequently (though not always) share qualitatively similar characteristics to market interventions that are often proposed for overcoming more conventional forms of market failure. Nevertheless, our analysis underscores the importance of understading the precise link between cognitive failures and market structure prior to the implementation any particular proposed reform. ∗The Economics and Management Department, The Open University of Israel. Email: [email protected]. Web: http://www.openu.ac.il/Personal_sites/Aviad-Heifetz/ . Support from the Hammer fund for Economic cooperation is gratefully acknowledged. †The Faculty of Management, Tel Aviv University. Email: [email protected] ‡Professor of Law, University of Southern California, Los Angeles, CA; Research Fellow, RAND Corporation, Santa Monica, CA. Email: [email protected]. Web: www.erictalley.com. Many thanks to Jennifer Arlen, Ian Ayres, Colin Camerer, Richard Craswell, and Ehud Kamar for helpful comments and discussions. All errors are ours.