Contract Design and Self-Control: Theory and Evidence

Stanford GSB Research Paper No. 1801

Posted: 29 Feb 2004

See all articles by Ulrike Malmendier

Ulrike Malmendier

University of California, Berkeley - Department of Economics; University of California, Berkeley - Haas School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); Institute for the Study of Labor (IZA)

Stefano DellaVigna

University of California, Berkeley; National Bureau of Economic Research (NBER)

Date Written: December 2003

Abstract

How do rational firms respond to consumer biases? In this paper, we analyze the profit-maximizing contract design of firms if consumers have time-inconsistent preferences and are partially naive about it. We consider markets for two types of goods: goods with immediate costs and delayed benefits (investment goods) such as health club attendance, and goods with immediate benefits and delayed costs (leisure goods) such as credit card-financed consumption. We establish three features of the profit-maximizing contract design with partially naive time-inconsistent consumers. First, firms price investment goods below marginal cost. Second, firms price leisure goods above marginal cost. Third, for all types of goods firms introduce switching costs and charge back-loaded fees. The contractual design targets consumer misperception of future consumption and underestimation of the renewal probability. The predictions of the theory match the empirical contract design in the credit card, gambling, health club, life insurance, mail order, mobile phone, and vacation timesharing industries. We also show that time inconsistency has adverse effects on consumer welfare only if consumers are naive.

Keywords: microeconomics, bahavioral economics, industrial organization, contact theory, applied theory

JEL Classification: D11, D12, D14, D18, D21, D40, D61, D91, D92

Suggested Citation

Malmendier, Ulrike and DellaVigna, Stefano, Contract Design and Self-Control: Theory and Evidence (December 2003). Stanford GSB Research Paper No. 1801, Available at SSRN: https://ssrn.com/abstract=509803

Ulrike Malmendier (Contact Author)

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Stefano DellaVigna

University of California, Berkeley ( email )

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