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Unrealistic Expectations and Misguided LearningAbstract:

We explore the learning process and behavior of an individual with unrealistically high expectations ("overconfidence") when outcomes also depend on an external fundamental that affects the optimal action. Moving beyond existing results in the literature, we show that the agent's beliefs regarding the fundamental converge under weak conditions. Furthermore, we identify a broad class of situations in which "learning" about the fundamental is self-defeating: it leads the individual systematically away from the correct belief and toward lower performance. Due to his overconfidence, the agent -- even if initially correct -- becomes too pessimistic about the fundamental. As he adjusts his behavior in response, he lowers outcomes and hence becomes even more pessimistic about the fundamental, perpetuating the misdirected learning. The greater is the loss from choosing a suboptimal action, the further the agent's action ends up from optimal. We partially characterize environments in which self-defeating learning occurs, and show that the decisionmaker learns to take the optimal action if, and in a sense only if, a specific non-identifiability condition is satisfied. In contrast to an overconfident agent, an underconfident agent's misdirected learning is self-limiting and therefore not very harmful. We argue that the decision situations in question are common in economic settings, including delegation, organizational, effort, and public-policy choices.

Joint with Paul Heidhues and Philipp Strack. Econometrica (2018), 86(4), pp. 1159-1214.

Naivete-Based DiscriminationAbstract:

We initiate the study of naivete-based discrimination, the practice of conditioning offers on external information about consumers' naivete. Knowing that a consumer is naive increases a monopolistic or competitive firm's willingness to generate inefficiency to exploit the consumer's mistakes, so naivete-based discrimination is not Pareto-improving, can be Pareto-damaging, and often lowers total welfare when classical preference-based discrimination does not. Moreover, the effect on total welfare depends on a hitherto unemphasized market feature: the extent to which the exploitation of naive consumers distorts trade with different types of consumers. If the distortion 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 distortion arises only for trades with sophisticated consumers, then perfect naivete-based discrimination maximizes social welfare, although imperfect discrimination often lowers welfare. And if the distortion 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.

Joint with Paul Heidhues. Quarterly Journal of Economics (2017), 132(2), pp. 1019-1054.

Inferior Products and Profitable DeceptionAbstract:

We analyze conditions facilitating profitable deception in a simple model of a competitive retail market. Firms selling homogenous products set anticipated prices that consumers understand and additional prices that naive consumers ignore unless revealed to them by a firm, where we assume that there is a binding floor on the anticipated prices. Our main results establish that "bad" products (those with lower social surplus than an alternative) tend to be more reliably profitable than "good" products. Specifically, (1) in a market with a single socially valuable product and sufficiently many firms, a deceptive equilibrium -- in which firms hide additional prices -- does not exist and firms make zero profits. But perversely, (2) if the product is socially wasteful, then 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. We apply our framework to the mutual-fund and credit-card markets, arguing that it explains a number of empirical findings regarding these industries.

Joint with Paul Heidhues and Takeshi Murooka. Review of Economic Studies (2017), 84(1), pp. 323-356.

Exploitative InnovationAbstract:

We analyze innovation incentives in a simple model of a competitive retail market with naive consumers. Firms selling perfect substitutes play a game consisting of an innovation stage and a pricing stage. At the pricing stage, firms simultaneously set a transparent "up-front price" and an "additional price," and decide whether to shroud the additional price from naive consumers. To capture especially financial products such as banking services, credit cards, and mutual funds, we allow for a floor on the product's up-front price. At the preceding innovation stage, a firm can invest either in increasing the product's value (value-increasing innovation) or in increasing the maximum additional price (exploitative innovation). We show that if the price floor is not binding, the incentive for either kind of innovation equal the "appropriable part" of the innovation, implying similar incentives for exploitative and value-increasing innovations. If the price floor is binding, however, innovation incentives are often stronger for exploitative than for value-increasing innovations. Because learning ways to charge higher additional prices increases the profits from shrouding and thereby lowers the motive to unshroud, a firm may have strong incentives to make appropriable exploitative innovations, and even stronger incentives to make non-appropriable exploitative innovations. In contrast, the incentive to make non-appropriable value-increasing innovations is zero or negative, and even the incentive to make appropriable value-increasing innovations is strong only if the product is socially wasteful. These results help explain why firms in the financial industry have been willing to make innovations others could easily copy, and why these innovations often seem to have included exploitative features.

Joint with Paul Heidhues and Takeshi Murooka. American Economic Journal: Microeconomics (2016), 8(1), pp. 1-23. [Lead Article, featured in AEA's research highlights.]

On the Welfare Costs of Naivete in the US Credit-Card MarketAbstract:

In the presence of naive consumers, a participation distortion arises in competitive markets because the additional profits from naive consumers lead competitive firms to lower transparent prices below cost. Using a simple calibration, we argue that the participation distortion in the US credit-card market may be large. Our results call for a redirection of some of the large amount of empirical research on the quantification of the welfare losses from market power, to the quantification of welfare losses that are due to the firms’ reactions to consumer misunderstandings.

Joint with Paul Heidhues. Review of Industrial Organization (2015), 47(3), pp. 341-354.

Behavioral Contract TheoryAbstract:

This review provides a critical survey of psychology-and-economics ("behavioral-economics") research in contract theory. First, I introduce the theories of individual decisionmaking most frequently used in behavioral contract theory, and formally illustrate some of their implications in contracting settings. Second, I provide a more comprehensive (but informal) survey of the psychology-and-economics work on classical contract-theoretic topics: moral hazard, screening, mechanism design, and incomplete contracts. I also summarize research on a new topic spawned by psychology and economics, exploitative contracting, that studies contracts designed primarily to take advantage of agent mistakes.

Journal of Economic Literature (2014), 52(4), pp. 1075-1118.

True Context-Dependent Preferences? The Causes of Market-Dependent ValuationsAbstract:

A central assumption of neoclassical economics is that reservation prices for familiar products express people’s true preferences for these products, that is, they represent the total benefit that a good confers to the consumers, and are thus, independent of actual prices in the market. Nevertheless, a vast amount of research has shown that valuations can be sensitive to other salient prices; particularly when individuals are explicitly anchored on them. In this paper, the authors extend previous research on single-price anchoring and study the sensitivity of valuations to the distribution of prices found for the product in the market. In addition, they examine its possible causes. They find that market-dependent valuations cannot be fully explained by rational inferences consumers draw about a product’s value, and are unlikely to be fully explained by true market-dependent preferences. Rather, the market dependence of valuations likely reflects consumers’ focus on something other than the total benefit that the product confers to them. Furthermore, this paper shows that market-dependent valuations persist when – as in many real-life settings – individuals make repeated purchase decisions over time and infer the distribution of the product’s prices from their market experience. Finally, the authors consider the implications of their findings for marketers and consumers.

Joint with Nina Mazar and Dan Ariely. Journal of Behavioral Decision Making (2014), 27; pp. 200-208.

Regular Prices and SalesAbstract:

It is widely known that loss aversion leads individuals to dislike risk, and as has been argued by many researchers, in many instances this creates an incentive for firms to shield consumers and employees against economic risks. Complementing previous research, we show that consumer loss aversion can also have the opposite effect: it can lead a firm to optimally introduce risk into an otherwise deterministic environment. We consider a profit-maximizing monopolist selling to a loss-averse consumer, where (following Kõszegi and Rabin (2006)) we assume that the consumer's reference point is her recent rational expectations about the purchase. We establish that for any degree of consumer loss aversion, the monopolist's optimal price distribution consists of low and variable "sale" prices and a high and atomic "regular" price. Realizing that she will buy at the sale prices and hence that she will purchase with positive probability, the consumer chooses to avoid the painful uncertainty in whether she will get the product by buying also at the regular price. This pricing pattern is consistent with several recently documented facts regarding retailer pricing. We show that market power is crucial for this result: when firms compete ex ante for consumers, they choose deterministic prices.

Joint with Paul Heidhues. Theoretical Economics (2014), 9; pp. 217-251. Older (2011) version.

A Model of Focusing in Economic ChoiceAbstract:

We present a generally applicable theory of focusing based on the hypothesis that a person focuses more on, and hence overweights, attributes in which her options differ more. Our model predicts that the decisionmaker is too prone to choose options with concentrated advantages relative to alternatives, but maximizes utility when the advantages and disadvantages of alternatives are equally concentrated. Applying our model to intertemporal choice, these results predict that a person exhibits present bias and time inconsistency when -- such as in lifestyle choices and other widely invoked applications of hyperbolic discounting -- the future effect of a current decision is distributed over many dates, and the effects of multiple decisions accumulate. But unlike in previous models, in our theory (1) present bias is lower when the costs of current misbehavior are less dispersed, helping to explain why people respond more to monetary incentives than to health concerns in harmful consumption; and (2) time inconsistency is lower when a person commits to fewer decisions with accumulating effects in her ex-ante choice. In addition, a person does not fully maximize welfare even when making decisions ex ante: (3) she commits to too much of an activity -- e.g., exercise or work -- that is beneficial overall; and (4) makes "future-biased" commitments when -- such as in preparing for a big event -- the benefit of many periods' effort is concentrated in a single goal.

Joint with Ádám Szeidl. Quarterly Journal of Economics (2013), 128(1); pp. 53-107. Older version.

Exploiting Naivete about Self-Control in the Credit MarketAbstract:

We analyze contract choices, loan-repayment behavior, and welfare in a model of a competitive credit market when borrowers have a taste for immediate gratification. Consistent with many credit cards and subprime mortgages, for most types of non-sophisticated borrowers the baseline repayment terms are cheap, but they are also inefficiently front-loaded and delays require paying large penalties. Although credit is for future consumption, non-sophisticated consumers overborrow, pay the penalties, and back-load repayment, suffering large welfare losses. Prohibiting large penalties for deferring small amounts of repayment -- akin to recent regulations in the US credit-card and mortgage markets -- can raise welfare.

Joint with Paul Heidhues. American Economic Review (2010), 100(5), pp. 2279-2303. Web Appendix (Proofs)

Utility from Anticipation and Personal EquilibriumAbstract:

I develop a dynamic model of individual decisionmaking in which the agent derives utility from physical outcomes as well as from rational beliefs about physical outcomes ("anticipation"), and these two payoff components can interact. Beliefs and behavior are jointly determined in a personal equilibrium by the requirement that behavior given past beliefs must be consistent with those beliefs. I explore three phenomena made possible by utility from anticipation, and prove that if the decisionmaker's behavior is distinguishable from a person's who cares only about physical outcomes, she must exhibit at least one of these phenomena. First, the decisionmaker can be prone to self-fulfilling expectations. Second, she might be time-inconsistent even if her preferences in all periods are identical. Third, she might exhibit informational preferences, where these preferences are intimately connected to her attitudes toward disappointments. Applications of the framework to reference-dependent preferences, impulsive behaviors, and emotionally difficult choices are discussed.

Economic Theory (2010), 44(3), 415-444.

Futile Attempts at Self-ControlAbstract:

We investigate costly yet futile attempts at self-control when consumption of a harmful product has a binary breakdown/no-breakdown nature and individuals tend to underestimate their need for self-control. Considering time-inconsistent preferences as well as temptation disutility, we show that becoming more sophisticated can decrease welfare and investigate what kind of mistaken beliefs lead to low welfare. With time-inconsistent preferences, being close to perfectly understanding one's preferences but assigning zero probability to true preferences induces the worst outcome.

Joint with Paul Heidhues. Journal of the European Economic Association (2009), 7(2-3), pp. 423-434.

Reference-Dependent Consumption PlansAbstract:

We develop a rational dynamic model in which people are loss averse over changes in beliefs about present and future consumption. Because changes in wealth are news about future consumption, preferences over money are reference-dependent. If news resonates more when about imminent consumption than when about future consumption, a decision maker might (to generate pleasant surprises) overconsume early relative to the optimal committed plan, increase immediate consumption following surprise wealth increases, and delay decreasing consumption following surprise losses. Since higher wealth mitigates the effect of bad news, people exhibit an unambiguous first-order precautionary-savings motive.
; Web Appendix

Joint with Matthew Rabin. American Economic Review (2009), 99(3), pp. 909-936.

Choices, Situations, and HappinessAbstract:

This article explores some conceptual issues in the study of well-being using the traditional economic approach of inferring preferences solely from choice behavior. We argue that choice behavior alone can never reveal which situations make people better off, even with unlimited data and under the maintained hypothesis of 100% rational choice. Ancillary assumptions or additional forms of data such as happiness measures are always needed. With such ancillary assumptions and additional data, however, the use of revealed preference to study well-being can be significantly improved, so that the choices people make can jointly identify preferences, mistakes, and well-being.

Joint with Matthew Rabin. Journal of Public Economics (2008), 92, pp. 1821-1832.

Competition and Price Variation when Consumers are Loss AverseAbstract:

We modify the Salop (1979) model of price competition with differentiated products by assuming that consumers are loss averse relative to a reference point given by their recent expectations about the purchase. Consumers' sensitivity to losses in money increases the price responsiveness of demand--and hence the intensity of competition--at higher relative to lower market prices, reducing or eliminating price variation both within and between products. When firms face common stochastic costs, in any symmetric equilibrium the markup is strictly decreasing in cost. Even when firms face different cost distributions, we identify conditions under which a focal-price equilibrium (where firms always charge the same "focal" price) exists, and conditions under which any equilibrium is focal. (JEL D11, D43, D81, L13)

Joint with Paul Heidhues. American Economic Review (2008), 98(4), pp. 1245-1268.

Drive and TalentAbstract:

We analyze ways in which heterogeneity in responsiveness to incentives (“drive”) affects employees’ incentives and firms’ incentive systems in a career concerns model. On the one hand, since more driven agents work harder in response to existing incentives than less driven ones—and therefore pay is increasing in perceived drive—there is a motive to increase effort to signal high drive. These “drive-signaling incentives” are strongest with intermediate levels of existing incentives. On the other hand, because past output of a more driven agent will seem to the principal to reflect lower ability, there is an incentive to decrease effort to signal low drive. The former effect dominates early in the career, and the latter effect dominates towards the end. To maximize incentives, the principal wants to observe a noisy measure of the agent’s effort—such as the number of hours he works—early but not late in his career.

Joint with Wei Li. Journal of the European Economic Association (2008), 6(1), pp. 210-236.

Reference-Dependent Risk AttitudesAbstract:

We use Kõszegi and Rabin’s (2006) model of reference-dependent utility, and an extension of it that applies to decisions with delayed consequences, to study preferences over monetary risk. Because our theory equates the reference point with recent probabilistic beliefs about outcomes, it predicts specific ways in which the environment influences attitudes toward modest-scale risk. It replicates “classical” prospect theory—including the prediction of distaste for insuring losses—when exposure to risk is a surprise, but implies first-order risk aversion when a risk, and the possibility of insuring it, are anticipated. A prior expectation to take on risk decreases aversion to both the anticipated and additional risk. For large-scale risk, the model allows for standard “consumption utility” to dominate reference- dependent “gain-loss utility,” generating nearly identical risk aversion across situations.

Joint with Matthew Rabin. American Economic Review (2007), 97(4), pp. 1047-1073. [Lead article.]

A Model of Reference-Dependent PreferencesAbstract:

We develop a model of reference-dependent preferences and loss aversion where “gain–loss utility” is derived from standard “consumption utility” and the reference point is determined endogenously by the economic environment. We assume that a person’s reference point is her rational expectations held in the recent past about outcomes, which are determined in a personal equilibrium by the requirement that they must be consistent with optimal behavior given expectations. In deterministic environments, choices maximize consumption utility, but gain–loss utility influences behavior when there is uncertainty. Applying the model to consumer behavior, we show that willingness to pay for a good is increasing in the expected probability of purchase and in the expected prices conditional on purchase. In within-day labor-supply decisions, a worker is less likely to continue work if income earned thus far is unexpectedly high, but more likely to show up as well as continue work if expected income is high.

Joint with Matthew Rabin. Quarterly Journal of Economics (2006), 121(4), pp. 1133-1166. [Lead article.]

Emotional AgencyAbstract:

This paper models interactions between a party with anticipatory emotions and a party who responds strategically to those emotions, a situation that is common in many health, political, employment, and personal settings. An “agent” has information with both decision-making value and emotional implications for an uninformed “principal” whose utility she wants to maximize. If she cannot directly reveal her information, to increase the principal’s anticipatory utility she distorts instrumental decisions toward the action associated with good news. But because anticipatory utility derives from beliefs about instrumental outcomes, undistorted actions would yield higher ex ante total and anticipatory utility. If the agent can certifiably convey her information, she does so for good news, but unless this leads the principal to make a very costly mistake, to shelter his feelings she pretends to be uninformed when the news is bad.

Quarterly Journal of Economics (2006), 121(1), pp. 121-156

Ego Utility, Overconfidence, and Task ChoiceAbstract:

This paper models behavior when a decision maker cares about and manages her self-image. In addition to having preferences over material outcomes, the agent derives “ego utility” from positive views about her ability to do well in a skill-sensitive, “ambitious,” task. Although she uses Bayes’ rule to update beliefs, she tends to become overconfident regarding which task is appropriate for her. If tasks are equally informative about ability, her task choice is also overconfident. If the ambitious task is more informative about ability, she might initially display underconfidence in behavior, and, if she is disappointed by her performance, later become too ambitious. People with ego utility prefer to acquire free information in smaller pieces. Applications to employee motivation and other economic settings are discussed.

Journal of the European Economic Association (2006), 4(4), pp. 673-707. [Lead article, winner of the 2008 Hicks-Tinbergen Medal for the best paper published in the Journal of the European Economic Association in the years 2006/2007.]

Tax Incidence when Individuals are Time-Inconsistent: The Case of Cigarette Excise TaxesAbstract:

One of the most cogent criticisms of excise taxes is their regressivity, with lower income groups spending a much larger share of their income on goods such as cigarettes than do higher income groups. We argue that traditional quantity-based measures of incidence are only appropriate under a very restrictive ‘‘time-consistent’’ model of consumption of sin goods. A model that is much more consistent with existing evidence on smoking decisions is a time-inconsistent formulation where excise taxes on cigarettes serve a self-control function that is valued by smokers who would like to quit but cannot. This self-control function benefits lower income groups more, since they have a significantly higher price sensitivity of smoking. Calibrations show that, as a result, cigarette taxes are much less regressive than previously assumed, and are even progressive for a wide variety of parameter values.

Joint with Jonathan Gruber. Journal of Public Economics (2004), 88(9-10), 1959-1987

Health Anxiety and Patient BehaviorAbstract:

Economic models of patient decision-making emphasize the costs of getting medical attention and the improved physical health that results from it. This note builds a model of patient decision-making when fears or anxiety about the future—captured as beliefs about next period’s state of health— also enter the patient’s utility function. Anxiety can lead the patient to avoid doctor’s visits or other easily available information about her health. However, this avoidance cannot take any form: she will never avoid the doctor with small problems, and under regularity conditions she will never go to a bad doctor to limit the information received.

Journal of Health Economics (2003), 22(6), pp. 1073-1084

Quasi-Hyperbolic Discounting and RetirementAbstract:

Some people have self-control problems regularly. This paper adds endogenous retirement to Laibson’s quasi-hyperbolic discounting savings model [Quarterly Journal of Economics 112 (1997) 443–477]. Earlier selves think that the deciding self tends to retire too early and may save less to induce later retirement. Still earlier selves may think the pre-retirement self does this too much, saving more to induce early retirement. The consumption pattern may be different from that with exponential discounting. Other observational non-equivalence includes the impact of changing mandatory retirement rules or work incentives on savings and a possibly negative marginal propensity to consume out of increased future earnings. Naive agents are briefly considered.

Joint with Peter Diamond. Journal of Public Economics (2003), 87(9-10), pp. 1839-1872 [Lead article.]

Is Addiction `Rational?' Theory and EvidenceAbstract:

This paper makes two contributions to the modeling of addiction. First, we provide new and convincing evidence that smokers are forward-looking in their smoking decisions, using state excise tax increases that have been legislatively enacted but are not yet effective, and monthly data on consumption. Second, we recognize the strong evidence that preferences with respect to smoking are time inconsistent, with individuals both not recognizing the true difficulty of quitting and searching for self-control devices to help them quit. We develop a new model of addictive behavior that takes as its starting point the standard “rational addiction” model, but incorporates time-inconsistent preferences. This model also exhibits forward-looking behavior, but it has strikingly different normative implications; in this case optimal government policy should depend not only on the externalities that smokers impose on others but also on the “internalities” imposed by smokers on themselves. We estimate that the optimal tax per pack of cigarettes should be at least one dollar higher under our formulation than in the rational addiction case.

Joint with Jonathan Gruber. Quarterly Journal of Economics (2001), 116(4), pp. 1261-1305

Comparison of Magnetocaloric Properties from Magnetic and Thermal MeasurementsAbstract:

The isothermal change of the magnetic entropy of a magnetically ordered material upon application of external magnetic field can be calculated from the temperature and field dependence of the magnetization or of the specific heat. The adiabatic temperature change, i.e., the magnetocaloric effect ~MCE! can be measured directly or can be calculated via different methods using the field-dependent specific heat values, or a combination of data obtained via magnetization and thermal measurements. In the present study, magnetic and thermal measurements were carried out on Gd75Y25(TC=232 K) and Gd48Y52(TC=161 K) samples, for applied fields ranging between 0 and 7 T. From both datasets, the magnetic entropy change and MCE values were calculated and compared, in order to assess the mutual reliability of the methods applied. The magnetically or thermally deduced specific heat discontinuities show a reasonable agreement within experimental error. Similar comparison of the calculated magnetic entropy changes reveals that the measured transition temperature and the shape of the curve do not depend on the method selected. It is demonstrated that the choice of an integration constant during entropy calculation has a significant impact on the adiabatic temperature change deduced from the field and temperature dependence of the entropies. For the MCE, a better approximation can be obtained using the magnetically acquired magnetic entropy change and the field-dependent specific heat. The results prove that magnetic measurements carried out in high enough magnetic fields provide reliable information on the isothermal magnetic entropy change and, when combined with field-dependent specific heat measurements, on the magnetocaloric effect as well.

Joint with M. Foldeaki, W. Schnelle, E. Gmelin, P. Benard, A. Giguere, R. Chahine, and T. K. Bose. Journal of Applied Physics (1997), 82(1), pp. 309-316