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Contract Design and Self Control: Theory and Evidence

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Author Info
Malmendier, Ulrike M. (Stanford U)
Della Vigna, Stefano (U of California, Berkeley)
Abstract

How do rational firms respond to consumer biases? In this paper, we analyze the profit-maximizing contract design of firms if consumers have time-inconsistent preferences and are partially naive about it. We consider markets for two types of goods: goods with immediate costs and delayed benefits (investment goods) such as health club attendance, and goods with immediate benefits and delayed costs (leisure goods) such as credit card-financed consumption. We establish three features of the profit-maximizing contract design with partially naive time-inconsistent consumers. First, firms price investment goods below marginal cost. Second, firms price leisure goods above marginal cost. Third, for all types of goods firms introduce switching costs and charge back-loaded fees. The contractual design targets consumer misperception of future consumption and underestimation of the renewal probability. The predictions of the theory match the empirical contract design in the credit card, gambling, health club, life insurance, mail order, mobile phone, and vacation timesharing industries. We also show that time inconsistency has adverse effects on consumer welfare only if consumers are naive.

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Paper provided by Stanford University, Graduate School of Business in its series Research Papers with number 1801.

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Date of creation: Dec 2003
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Handle: RePEc:ecl:stabus:1801

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  1. Laibson, David, 1997. "Golden Eggs and Hyperbolic Discounting," The Quarterly Journal of Economics, MIT Press, vol. 112(2), pages 443-77, May.
  2. Akerlof, George A & Yellen, Janet L, 1985. "Can Small Deviations from Rationality Make Significant Differences to Economic Equilibria?," American Economic Review, American Economic Association, vol. 75(4), pages 708-20, September. [Downloadable!] (restricted)
  3. Ausubel, Lawrence M, 1991. "The Failure of Competition in the Credit Card Market," American Economic Review, American Economic Association, vol. 81(1), pages 50-81, March.
  4. De Long, J Bradford & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1990. "Noise Trader Risk in Financial Markets," Journal of Political Economy, University of Chicago Press, vol. 98(4), pages 703-38, August. [Downloadable!] (restricted)
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  5. Russell, Thomas & Thaler, Richard, 1985. "The Relevance of Quasi Rationality in Competitive Markets," American Economic Review, American Economic Association, vol. 75(5), pages 1071-82, December. [Downloadable!] (restricted)
  6. Becker, Gary S & Murphy, Kevin M, 1988. "A Theory of Rational Addiction," Journal of Political Economy, University of Chicago Press, vol. 96(4), pages 675-700, August. [Downloadable!] (restricted)
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  1. Yianis Sarafidis, 2004. "Inter-temporal Price Discrimination with Time Inconsistent Consumers," Econometric Society 2004 North American Summer Meetings 479, Econometric Society. [Downloadable!]
  2. Drew Fudenberg & David K Levine, 2005. "A Dual Self Model of Impulse Control," Levine's Working Paper Archive 618897000000000876, UCLA Department of Economics. [Downloadable!]
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