Overconfident Consumers in the Marketplace

Abstract

The term overconfidence is used broadly in the psychology literature, referring to both overoptimism and overprecision. Overoptimistic individuals overestimate their own abilities or prospects. In contrast, overprecise individuals place overly narrow confidence intervals around forecasts, thereby underestimating uncertainty. These biases can lead consumers to misforecast their future product usage, or to overestimate their abilities to navigate contract terms. In consequence, consumer overconfidence causes consumers to systematically misweight different dimensions of product quality and price. Poor choices based on biased estimates of a product's expected costs or benefits are the result. For instance, overoptimism about self-control is a leading explanation for why individuals overpay for gym memberships that they underutilize. Similarly, overprecision is a leading explanation for why individuals systematically choose the wrong calling plans, racking up large overage charges for exceeding usage allowances in the process. Beyond these market effects of overconfidence, this paper addresses three additional questions: What will firms do to exploit consumer overconfidence? What are the equilibrium welfare consequences of consumer overconfidence for consumers, firms, and society? And what are the implications of consumer overconfidence for public policy?