On the Welfare Costs of Naiveté in the US Credit-Card Market

Abstract

In the presence of naive consumers, a participation distortion arises in competitive markets because the additional profits from naive consumers lead competitive firms to lower transparent prices below cost. Using a simple calibration, we argue that the participation distortion in the US credit-card market may be massive. Our results call for a redirection of some of the large amount of empirical research on the quantification of the welfare losses from market power, to the quantification of welfare losses that are due to the firms’ reactions to consumer misunderstandings.