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## Preference coefficients, learning and choice probabilities

Now that we have specified how quantities and prices are determined, what happens in the market depends on the actual visits of buyers to sellers: sellers are chosen by buyers according to certain probabilities. The latter are derived from " preference coefficients " which are built upon the history of each buyer's past profits with each seller. The learning and probabilistic choice processes to be described in this section are the "invariant core" of the model. They are largely inspired from the formal neural networks approach to reinforcement learning as described for instance in Weisbuch (1990). They will not be modified in any of the subsequent versions of the model (which is not the case for the simple rules for choosing price and quantities described above).

Let first specify the learning process of the buyers. By assumption the only information available to them come from previous transactions. We first propose to map that information into preference coefficients of buyer i for seller j. These are constructed by recording the profits that buyer i made from his previous transaction with seller j. At the same time these previous profits are discounted at a constant rate . Since we use discrete time for transactions, preferences are updated at each time step according to:

In other words, at each time step, all preferences coefficients are discounted at a constant rate, while the preference coefficient for the shop with which a transaction occurs is increased by the profit made in that shop. Discounting previous profits at a constant rate is important in ensuring that information is relevant to the current situation: in general, shops do not have stationary characteristics in terms of the profits that they offer because of changes in prices or the level of their supply with respect to the number of customers they have to serve. Preference coefficents thus appear as the sum of discounted past profits.

Buyers then use these preference coefficents to choose a shop. One way to do so is to choose the shop with the best record, that is the shop with the highest . However, by always doing this, the buyer will become a captive of the selected shop which would then be in a position to increase its prices, thus diminishing the buyer's profit. The shop can do this until the buyer's profit becomes negative before running any risk of losing that buyer. It is therefore in the buyer's interest to search from time to time among other sellers to check whether he could get a better profit elsewhere. In other words, a good strategy for the buyers would be a balance between the deterministic choice in favor of those shops which gave the best profits in the past and random search among other sellers. This raises the well known issue of the trade-off between exploitation of old knowledge and exploration to acquire new knowledge. We suppose here that a buyer chooses a shop j with a probability which is proportional to the exponential of the preference coefficient for that shop. That is:

where measures the non-linearity of the relationship between the probability and the preference coefficient .

The exponential rule has been widely used in economics and elsewhere. In particular, several justifications for its use are given in the discrete choice literature, see e.g. Anderson et al. (1992).

In our case, the exponential rule can be derived directly. This is done by maximizing the weighted sum F of two terms, one of which favors immediate profit and the other which favors search. To maximise information gain during visits, buyers should maximize the Shannon entropy of the distribution of search probabilities:

The function F to be maximized is then a linear combination of preferences and entropy terms:

Setting the derivatives with respect to equal to zero under the constraint that the sum of the probabilities is 1 gives equation 6. is then simply interpreted as the relative weight of the discounted sum of profits with respect to the amount of information in function F.

Next: Mean Field Approach Up: The simplest Model Previous: Prices and quantities

weisbuch
Mon Feb 10 13:26:18 GMT+0100 1997