WORKING PAPERS





Exploiting Naivete about Self-Control in the Credit MarketAbstract:

We analyze behavior and welfare in a competitive credit market where borrowers with different tastes for immediate gratification and prior beliefs about that taste sign long-term contracts specifying a loan amount and a menu of repayment schedules. Consistent with many credit-card and mortgage contracts, a competitive-equilibrium contract features an advantageous schedule involving overly front-loaded repayment, but imposes a discontinuous fee for any delay relative to this schedule. Fully sophisticated borrowers repay at the fast rate, but all other borrowers, including those with an arbitrarily small amount of naivete, put off the bulk of the repayment to later. Furthermore, because non-sophisticated borrowers believe they will repay quickly, they underestimate the cost of credit, and hence borrow too much given their preferences at the time of signing. Due to these mistakes, non-sophisticated consumers have discontinuously lower welfare than sophisticated ones. We identify natural conditions under which the above results obtain even if firms observe neither a consumer's taste for immediate gratification nor her beliefs -- because all non-sophisticated consumers endogenously choose contracts for which they discretely mispredict their future behavior. Requiring credit contracts to have a linear structure prevents non-sophisticated but not-too-naive borrowers from severely mispredicting their behavior, so this intervention can raise welfare.

(with Paul Heidhues). Revised February 2008.





A Failure of the No-Arbitrage PrincipleAbstract:

Underlying the principle of no arbitrage is the assumption that markets eliminate any opportunity for risk-free profits. In contrast, we document a pricing mistake by a $200 million company that allowed investors a guaranteed return of 25.6% in a few days, and that resulted in less than $60,000 being invested into exploiting the opportunity.

(with Kristóf Madarász and Máté Matolcsi). Appendix. Revised September 2007.





The Impact of Consumer Loss Aversion on PricingAbstract:

We develop a model in which a profit-maximizing monopolist with uncertain cost of production sells to loss-averse, rational consumers. We first introduce techniques for analyzing the demand of such consumers, and then investigate the monopolist’s pricing strategy. Compared to lower possible purchase prices, paying a higher price in the firm’s pricing distribution is assessed by consumers as a loss, decreasing demand for the firm’s product. We provide conditions under which a firm with continuously distributed marginal cost responds by (locally) eliminating this “comparison effect” and choosing a discrete price distribution; that is, prices are “sticky”. Price stickiness is more likely to obtain when the cost distribution has high density, the price responsiveness of demand is low, or consumers are likely to purchase. Whether or not prices are sticky, the monopolist wants to at least mitigate the comparison effect, leading to countercyclical markups. On the other hand, if consumers expect to buy the product, they experience a loss if they end up not consuming it, increasing their willingness to pay for it. Thus, despite the tendency toward price stability, there are also circumstances in which a firm with unchanging cost offers random “sales” to increase customers’ expectation to consume, attracting more demand at higher prices.

(with Paul Heidhues). Revised May 2005.





Price-Sensitive PreferencesAbstract:

One of the foundational assumptions of neoclassical economics is that individual choice behavior reflects underlying stable preferences. A crucial implication of this assumption is that willingness to pay for a product is independent of the prices consumers face for the product at the moment. We test this implication by using the Becker-DeGroot-Marschak procedure, a widely used experimental method to measure individuals’ valuations for consumption goods and other experiences. This procedure allows us to vary the possible prices for a given product across participants, while at the same time eliciting preferences in an incentive compatible manner. We find that valuations for simple goods (mugs and chocolates) are extremely sensitive to the shape of the price distribution: They are several times higher when the price distribution is skewed to the right than when it is skewed to the left. We also show that this sensitivity is not due to participants’ inferences about the value of the good made from the price distribution. Based on these findings, we demonstrate that neoclassical estimates of the elasticity of demand, consumer welfare, and the excess burden from market intervention—estimates that depend heavily on preference stability—can be systematically biased. Finally, since our results pose a problem for measurement of preferences and their welfare implications, we introduce two variants of the basic procedure, and find that these approaches can substantially reduce the dependency of valuations on the price distribution.

(with Dan Ariely and Nina Mazar). Revised June 2004.