Will Governments Fix What Markets Cannot? The Positive Political Economy of Regulation in Markets with Overconfident Consumers

Abstract

A standard theoretical and empirical claim in the behavioral industrial organization literature is that market forces may not always eliminate the negative welfare consequences of biased consumer behavior, even in competitive markets. In this literature, government regulations are often proposed that would succeed in raising social welfare in the face of consumer biases and could therefore serve as substitutes for market forces. It is not obvious, however, that a self-governing group of citizen-consumers would choose to enact this welfareimproving policy. We show that in the case of markets for goods with add-ons (Gabaix and Laibson, 2006) the instances in which markets or government will fail to correct for consumer biases (in our model, consumer overcondence about add-on services such as overdraft fees) are similar. In the same cases in which markets are inecient due to the prevalence of biased consumers, voters will not demand eciency-enhancin g regulations. Consumer biases have two eects: they produce deadweight losses, and they redistribute income from biased consumers to less-biased consumers. The distributional consequences often both prevent equilibrium competition by rms from enhancing eciency and prevent equilibrium policy choices by citizens from regulating away inecient trade.