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Using Information about Naivete to Price DiscriminateAbstract:

We study the welfare effects of an increase in firms' information about consumer naivete in a simple reduced-form model in which competitive firms can introduce distortionary fees that naive consumers ignore when making purchase decisions. We establish that our model captures many markets---including those for credit, banking, hotels, gambling, and mobile phones---in which consumer naivete has been invoked as playing an important role. While in natural analogues with rational consumers (we show) seller information about consumers always increases social welfare, we identify arguably weak conditions under which seller information about consumer naivete lowers welfare. When some consumers are naive, a participation distortion arises because the additional profits from naive consumers lead competitive firms to lower transparent prices below cost, and an exploitation distortion arises from the socially costly hidden fees firms charge. Due to seller information about consumer naivete, (i) the participation distortion increases unless the demand curve is sufficiently concave; (ii) the exploitation distortion increases if the social cost of hidden fees satisfies decreasing absolute convexity; and (iii) the interaction of the two effects further lowers social welfare. We also identify conditions under which perfect seller information about consumer naivete hurts both types of consumers.

Joint with Paul Heidhues. Updated March 2014.

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 January 2014.

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. Updated December 2012.