Cursed Financial InnovationAbstract:
We analyze the welfare properties of derivative securities that profit-maximizing issuers offer to investors who have inferior information and neglect the information content of the offer. To capture the markets for structured securities and exotic exchange-traded funds, we assume that issuers can choose both the underlying asset and the form of the security. An issuer's optimal security induces investors to bet on unlikely market movements, creating both excess risk taking and undersaving. Giving more information to the issuer leads it to choose an underlying asset on which its information is more extreme, exacerbating both effects and hence lowering social welfare. Furthermore, providing inferior and noisy additional information to investors also lowers welfare because the security is then written on an underlying asset about which the information is misleading. If the issuer can base its security on a combination of underlying assets, it optimally creates a "custom-designed" index to maximize its informational advantage and minimize risk, minimizing investor and social welfare. Restricting the set of underlying assets -- a kind of standardization -- increases welfare by preventing the issuer from systematically selling a security with extreme or misleading information. Once this policy is adopted, increasing investor information becomes beneficial.
Joint with Péter Kondor. Updated August 2015.
We study the welfare effects of naivete-based discrimination, the practice of conditioning offers on external information about consumers' naivete. Using a simple reduced-form model, we delineate three qualitatively distinct cases based on the "distortionary impact" of naivete -- the extent to which the exploitation of naive consumers distorts trades with different types of consumers. If the distortionary impact is homogenous across naive and sophisticated consumers, then under an arguably weak and empirically testable condition, naivete-based discrimination lowers total welfare. In contrast, if the distortionary impact arises only for trades with sophisticated consumers, then perfect naivete-based discrimination maximizes social welfare, although imperfect discrimination often lowers welfare. And if the distortionary impact arises only for trades with naive consumers, then naivete-based discrimination has no effect on welfare. We identify applications for each of these cases. In our primary example, a credit market with present-biased borrowers, firms lend more than socially optimal to increase the amount of interest naive borrowers unexpectedly pay, creating a homogenous distortion. The condition for naivete-based discrimination to lower welfare is then weaker than prudence. We discuss how to combine our results with empirical findings to determine whether naivete-based discrimination is welfare-decreasing in other settings.
Joint with Paul Heidhues. Updated October 2015.
Inferior Products and Profitable DeceptionAbstract:
We analyze conditions facilitating profitable deception in a simple model of a competitive retail market. Firms selling homogenous products simultaneously set a transparent up-front price and an additional price, and decide whether to unshroud the additional price to naive consumers. To model especially financial products such as banking services, credit cards, and mutual funds, we assume that there is a binding floor on the product's up-front price. Our main results establish that "bad" products - ones that should not even be produced - tend to be more reliably profitable than "good" products. Specifically, (1) in a market with a single socially valuable product and sufficiently many firms, at least one firm is willing to unshroud, so a deceptive equilibrium does not exist and firms make zero profits. But perversely, (2) if the product is socially wasteful, a firm cannot profitably sell a transparent product, so there is no incentive to unshroud and hence a profitable deceptive equilibrium always exists. Furthermore, (3) in a market with multiple products, since a superior product both diverts sophisticated consumers and renders an inferior product socially wasteful in comparison, it guarantees that firms can profitably sell the inferior product by deceiving consumers.
Joint with Paul Heidhues and Takeshi Murooka. Updated December 2014.