Contracting with Diversely Naive Agents

Abstract

A principal contracts with agents who have diverse abilities to forecast changes in their future tastes. While the principal knows that the agent's tastes are changing, the agent believes that with probability [theta], their future preferences will be identical to their present preferences. The principal does not observe [theta], but knows the probability distribution from which it is drawn. Thus, the agent's prior probability [theta] is their 'private type', and the principal has to offer a menu of contracts in order to screen the agent's type. We provide a full characterization of the principal's optimal menu. The results allow us to interpret some real-life contractual arrangements in a variety of examples.

Keywords: Contracts, dynamic inconsistency, naivety, non-common priors

JEL Classification: L12, L14