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Consumer Vulnerability and Behavioral Biases

Author

Listed:
  • Hanming Fang

    (University of Pennsylvania)

  • Zenan Wu

    (Peking University)

Abstract

A wealth of evidence shows that individuals are biased and ?rms can often exploit consumers’ behavioral biases in their contract designs. In this paper, we study how vulnerable biased individuals are to their own behavioral biases in market equilibrium, and focus on the role of risk aversion and intertemporal elasticity of substitution (IES). We measure consumer vulnerability by the percentage loss in a consumer’s equilibrium certainty equivalent from a market with non-biased consumers to that with biased ones. We examine several important behavioral biases that have been extensively studied in the literature, including the impact of biased beliefs (either over- or under-con?dence) in an insurance market, the impact of present bias and na¨ivete about present bias in a dynamic model of credit contract design, the impact of projection bias about habit formation, and the impact of expectation-based loss aversion on an investor’s portfolio choice. We show that consumer vulnerability to all four commonly studied behavioral biases has a non-monotonic relationship with risk aversion or IES. This is in striking contrast to the deviations in the equilibrium allocations from the rational benchmark, which are often monotonic to the risk aversion or IES. We also consider a setting of biased agents with Epstein-Zin preferences to isolate the e?ect of risk aversion from that of IES.

Suggested Citation

  • Hanming Fang & Zenan Wu, 2020. "Consumer Vulnerability and Behavioral Biases," PIER Working Paper Archive 20-036, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
  • Handle: RePEc:pen:papers:20-036
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    Cited by:

    1. Fang, Hanming & Wu, Zenan, 2020. "Life insurance and life settlement markets with overconfident policyholders," Journal of Economic Theory, Elsevier, vol. 189(C).

    More about this item

    Keywords

    Behavioral Biases; Welfare; Vulnerability; Biased Belief; Present Bias; Projection Bias; Prospect Theory; Loss Aversion; Epstein-Zin Preferences;
    All these keywords.

    JEL classification:

    • D60 - Microeconomics - - Welfare Economics - - - General
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making

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