We initiate the study of naivete-based discrimination, the practice of conditioning offers on external information about a consumer's naivete. We identify a broad class of situations in which such discrimination lowers social welfare under a weak condition. In our primary example, a credit market with time-inconsistent borrowers, firms lend more than socially optimal to increase profits from naive borrowers' unexpected eagerness to put off repayment. Information about consumer naivete leads firms to (inefficiently) differentiate the extent of overlending according to naivete as well as to (also inefficiently) raise total lending -- so that naivete-based discrimination always lowers welfare. Because the overlending distortion is the same whether or not firms observe beliefs, information about a consumer's beliefs has at most distributional implications, while information about naivete given beliefs always strictly decreases total welfare. We show that naivete-based discrimination follows a closely related logic in many other applications, including models of bank accounts and mobile phones, where the distortion from exploiting naivete falls homogenously on naive and sophisticated consumers. We also point out important settings in which the distortion differs across types, and identify the effect of information about naivete in some of those cases.
Joint with Paul Heidhues. Updated April 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.