Seemingly Exploitative Contracts

Abstract

This paper studies sequential price discrimination of sophisticated present-biased consumers in the credit market. The optimal contract utilizes present bias to improve screening by inducing certain consumers to over-consume and over-accumulate debt. This shows that the optimal contract can have features that seem exploitative. In essence, these features cause certain consumers to experience ex-post welfare losses even when they are sophisticated. If the intention of firms is to screen and not exploit consumers, then financial regulations aimed at protecting consumers by eliminating seemingly exploitative features could introduce additional distortions. In contrast, contracts that are truly exploitative induce over-consumption and over-accumulation of debt by taking advantage of the incorrect beliefs of non-sophisticated consumers.