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.





Reference-Dependent Consumption PlansAbstract:

We develop a dynamic model in which utility depends on consumption as well as recent changes in beliefs about present and future consumption, and bad news is more painful than good news is pleasant. We assume behavior must meet the rational-consistency condition that the person believes her own plans: given the expectations generated by a plan, in each period the plan maximizes discounted expected utility taking into account that continuation plans must also be consistent with rationality. Applying our model to the acquisition of decision-irrelevant information, we show that (1) to avoid fluctuations in beliefs, a person prefers to receive information clumped together rather than separately, and (2) because updating beliefs has lower utility impact when about outcomes that are further in the future, she prefers learning information earlier to later. Because wealth changes constitute news about the distribution of future consumption, our model predicts ways in which the decisionmaker exhibits reference-dependent attitudes toward current changes in wealth—even though she holds wealth exclusively for future consumption and faces substantial uncertainty about future income. We also apply our theory to a two-period consumption-savings problem. Since raising current consumption above the planned level may be very pleasant, a decisionmaker might overconsume early relative to the optimal committed plan. While the greater aversion to losses from lowering plans for future consumption can deter this tendency when consumption plans are deterministic, uncertain plans mitigate this asymmetry, so overconsumption is exacerbated by current uncertainty. Because a surprise increase in lifetime wealth is most pleasant, and a surprise decrease most unpleasant, if consumed immediately, a person responds asymmetrically to surprises. And since higher consumption reduces the sensation of loss from lower-than-expected consumption, a person prepares for anticipated uncertainty about future income with a first-order increase in current saving.

(with Matthew Rabin). Revised January 2008.





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.





Utility from Anticipation and Personal EquilibriumAbstract:

This paper proposes a general dynamic model of individual decisionmaking in which the agent derives utility from physical outcomes as well as from expectations regarding physical outcomes (“anticipation”), and these two payoff components can interact. At the heart of the theory is a new solution concept, personal equilibrium, to determine behavior in this context. The paper explores three types of behavior made possible by utility from anticipation, and proves that if the decisionmaker is distinguishable from one 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, a person who has identical preferences in all periods can still be time inconsistent, and due to this time inconsistency, behavior can depend on unchosen alternatives. Third, the decisionmaker might in personal equilibrium exhibit informational preferences, and 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.

Revised August 2007. An older, more general, and significantly messier version: Anticipation in Observable BehaviorAbstract:

This paper asks the natural question: how is utility from anticipation reflected in behavior? I consider a general model of decisionmaking where rationally formed anticipation enters the agent’s utility function in addition to physical outcomes, and allow for interactions between these two payoff components. The paper explores three types of behavior made possible by utility from anticipation, and proves that if a decisionmaker who cares about anticipation is distinguishable from one who only cares about physical outcomes, she has to exhibit at least one of these phenomena. First, the agent can display informational preferences because she is not indifferent to insecurity, or because she cares about future disappointments. I prove that an agent who is indifferent to insecurity always prefers full to partial information if and only if she is disappointment averse, but a stronger condition is needed for her to prefer more information to less. Second, the agent can be time inconsistent because anticipatory feelings pass by the time she has to “invest” in them, and this time inconsistency can be reflected in intransitivity of choices. Third, the agent can be prone to self-fulfilling expectations. In developing these ideas, I also deal with several modeling difficulties when expectations enter utility.





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.