Equilibrium Effects in a General Model of Behavioral Biases

Abstract

I analyze a general model of consumer behavioral biases and firms' equilibrium reactions to them, in which I nest several different biases such as self-control issues, overconfidence, and inattention to salient prices, among others. I show that, absent other market failures, the existence of a behavioral bias lowers social welfare due to suboptimal consumption. When other market failures are present (such as the standard monopolist pricing distortion or adverse selection that induce underconsumption), behavioral bias might increase social welfare by counteracting the market failure (by inducing relative overconsumption) and moving the equilibrium closer to first-best. I show that many of the results that were previously shown for particular biases still hold in this more general setup. In particular, I show that consumers being able to purchase more products can exacerbate biases (even if the consumers perceive the utility from newly accessible products correctly), perfect competition does not cure the bias, that eliminating the bias can result in a lower consumer surplus and social welfare, and that firms do not have an incentive to educate naive consumers because (due to cross-subsidization) sophisticated consumers prefer to patronize firms that also sell to naive consumers.