Biased managers with network externalities
| Published date | 01 July 2023 |
| Author | Kangsik Choi,DongJoon Lee,Ki‐Dong Lee |
| Date | 01 July 2023 |
| DOI | http://doi.org/10.1111/sjpe.12340 |
1Graduate School of International Studies,
Pusan National University, Pusan, Korea
2Faculty of Economics, Osaka Sangyo
University, Daito-shi, Japan
3Graduate School of Business, Nagoya
University of Commerce and Business,
Nagoya, Japan
4Faculty of Economics & Commerce, Keimyung
University, Daegu, Korea
Correspondence
Ki-Dong Lee, Faculty of Economics &
Commerce, Keimyung University, 1095
Dalgubeol-daero, Dalseo-gu, Daegu 42601,
Korea.
Email: kdlee@kmu.ac.kr
Abstract
In network industry under Cournot and Bertrand competi-
tion, we examine a model when owners of firms hire biased
managers who have incorrect market demand. Contrast to
previous studies, we show that (i) regardless of the strength
of network externalities when consumers form the respon-
sive and passive expectations, owners realize strategic
advantage by hiring biased managers to be more aggressive
under Cournot and Bertrand competition, (ii) firms prefer
facing passive expectations for the weak network exter-
nalities and vice versa for the strong network exteranlities
under Bertrand and Cournot competition, (iii) if the network
size is sufficiently large, then the prisoner's dilemma that
firms hire aggressive managers no longer exists under both
competition modes. As with no delegation case, we obtain
the different rankings of firms' profit depending on both
network externalities and forming of expectations under
Cournot and Bertrand competition.
KEYWORDS
Bertrand, biased manager, Cournot, network externalities
JEL CLASSIFICATION
D43, L13, L14
ORIGINAL ARTICLE
Biased managers with network externalities
Kangsik Choi1 | DongJoon Lee2,3 | Ki-Dong Lee4
DOI: 10.1111/sjpe.12340
Received: 17 July 2021 Accepted: 18 October 2022
1 | INTRODUCTION
Recently, empirical studies have established that there seems to be a strong connection between individual manag-
ers' attitudes and corporate policies. In particular, overconfidence is a prominent behavioral bias of executives and
recent evidence indicates that a candidate's aggressiveness seems to be an important characteristic in hiring CEO
(Kaplan et al., 2012).1 Bertrand and Schoar (2003) showed that manager fixed effects matter for a wide range of
1 See Malmendier and Tate (2015) for survey and references therein.
201
Scott J Polit Econ. 2023;70:201–216. © 2022 Scottish Economic Society.wileyonlinelibrary.com/journal/sjpe
corporate decisions that vary with individual managers. Moreover, overconfident or underconfident behavior may
also vary across professions. Russo and Schoemaker (1992) showed that even if three groups of Shell's geologists,
public accountants and weather forecasters are characterized by systematic feedback and accountability, those
showed different biased behavior, with public accountants proving to be slightly underconfident.
Englmaier and Reisinger (2014) theoretically point out that hiring managers with biased beliefs can act as a
commitment device, and find that owners always hire aggressive managers regardless of competition mode.2 Their
results contrast with the classic literature on strategic delegation à la Fershtman and Judd (1987), Sklivas (1987),
and Vickers (1985): in the case of Cournot (Bertrand) competition, owners realize strategic advantage by inducing
managers to be more aggressive (defensive) in the product market. On the other hand, Prendergast and Stole (1996)
analyzed that the manager will exaggerate his own information; but ultimately, he becomes too conservative, being
unwilling to change his investments on the basis of new information suggesting that their previous behavior was
wrong. Moreover, Bolton et al. (2013) analyzed a theory of leadership that contrasts managerial resoluteness against
communication and listening skills within a firm. Their main conclusion of bright side of overconfidence is that more
resolute and overconfident CEOs perform better; see also Rotemberg and Saloner (2000) and Van Den Steen (2005)
for leadership and overconfidence. To the best of the authors' knowledge, some studies have attempted to compare
the Bertrand and Cournot outcomes which firms run by biased managers, however, previous studies ignore the issue
of comparison of consumer expectations in network industries.
With CEO overconfidence, a famous example of network industry is Stephen Case's merger of AOL with Time
Warner in 2000. Initially, the merger was served up as the penultimate marriage between Old Economy and New
Economy. However, as stock prices dropped, AOL's operating performance suffered and the merged company had to
write down $54 billion in goodwill related to the deal (Peers & Angwin, 2003). Two years later, AOL was still struggling
to meet expectations, and CEO Stephen Case being over-ambitious had been forced to resign.3
As with an anecdote, some crucial questions remain unanswered in the literature of network industries: (i) How
would the strength of network externalities affect CEO overconfidence? (ii) When consumers form different expecta-
tions for network externalities, would CEO overconfidence still prevail? This paper provides an analysis of managerial
beliefs and their impact on the strategic use of managerial incentives in network industries.
Recently, the burgeoning literature of information and communications technology (i.e., ICT) industry focuses
on network externalities since they arise in many industries, such as mobile phones and online social networks (see
Birke, 2009; Katz & Shapiro, 1985; Shy, 2001). Thus, the role of consumers' expectations formation is important
for not only consumers but also the firms' strategy in network industries. The existing literature in the presence
of network effects contains two different approaches to modeling rational expectations implying the passive and
responsive expectations terminology presented by Hurkens and Lopez (2014).4 Models with responsive expectations
implicitly assume that expectations adjust perfectly to match the realized demands for all prices. Conversely, models
with passive expectations assume that consumers hold their expectation of total demand fixed, irrespective of firms'
price choices. Rationality is then obtained by imposing that fixed expectations are correct at the equilibrium prices.
Our main results and insights are derived by comparing the scenarios with fully informed consumers (i.e., respon-
sive expectations) and fully uninformed consumers (i.e., passive expectations) for network industry. In general,
consumers could draw inferences about expected quantities from network goods, if they can observe them. Consum-
ers' inferences could directly affect their own demand given network effects. As with consumer's expectation for
our model, Koski and Kretschmer (2004, p. 16) states that “as a survey by Computerworld in 1995 shows, 80% of
respondents (information system professionals) found pre-announcements useful for planning purposes and 91%
welcomed the release of the planned product specifications of products due for release within the next year.” In this
2 See also Yu (2014), Nakamura (2019) and Meccheri (2021) for biased managers with investment decision, endogenous market and vertical structures.
3 See Besanko et al. (2017, chapter 2) for merger of AOL with Time Warner.
4 See Hagiu and Halaburda (2014) for this mixed or hybrid case. Griva and Vettas (2011) found that competition under no commitment to expectations
(i.e., passive expectations) tends to be more intense and results in larger market shares captured by the high-quality firm, relative to the case with
commitment to fixed expectations.
CHOI et al.
202
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