Rational Inattention as an Empirical Framework for Discrete Choice and Consumer-Welfare Evaluation

Abstract

The conventional discrete-choice model of demand assumes that consumers are fully informed about every available product alternative. This assumption is at odds with the large body of literature studying incomplete information and the role of the consumer's “evoked set” or “consideration set.” The author develops a novel empirical discrete-choice demand model derived from an underlying theory of consumers' rational inattention. The model distinguishes between factors that shift demand through the utility function, such as prices and product attributes, and factors that shift demand through the consumer's information “evaluation costs.” The author conducts an empirical case study of the laundry detergent category. Using a set of exclusion restrictions based on retail promotional instruments, specification tests select the rational inattention model over the conventional full-information discrete-choice model. Exploiting the launch of Tide Pods midway through the sample, the author demonstrates the role of evaluation costs for the measured value creation from a new product. A conventional discrete-choice model always assigns positive incremental consumer value from new products. However, the rational inattention model developed herein finds a decrease in overall consumer welfare from the new Tide Pods’ entry, with the increased friction in information associated with the larger choice set offsetting the potential gains from higher match value.

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