Bounded Rationality and Industrial Organization

By Ran Spiegler | Go to book overview

5
Biased Beliefs without
Dynamic Inconsistency
In Chapters 2–4, we devoted considerable attention to what we referred to as “naivete”—namely, biased beliefs that consumers hold regarding their future preferences. However, naivete was always discussed in the context of dynamically inconsistent preferences. Consumers had definite first-period preferences over their second-period consumption options; these preferences changed in the second period, and naivete meant underestimating the magnitude or likelihood of this change.In this chapter, we discuss situations in which consumers hold biased beliefs regarding their future preferences, without any element of dynamic inconsistency. In the two-period models we shall examine, the consumer’s second-period preferences over consumption alternatives are “state-dependent.” In the first period he holds a belief over the possible states. Firms possess different prior beliefs, and we as modelers judge those as unbiased.So far this is just like the two-period models in Chapters 2–4. The difference is that in the present chapter, the consumer will not have a distinct first-period preference relation over second-period market outcomes. In the first period, he will choose a price scheme as a standard expected utility maximizer, whose beliefs happen to be judged by the modeler as biased. In this respect, this chapter—unlike most others in this book—stays within the boundaries of the standard model of consumer choice. The primary reason for includingitisits linkage with the market models inhabited by naive, dynamically inconsistent consumers.We will consider three types of systematic belief biases:
1 Over-optimism. One future state may be “better” than another, in the sense that if consumers could choose between them, they would choose the former. Beliefs are over-optimistic if they systematically assign excessive probability to the good states. For instance, a consumer who is about to sign up for a cable TV package may be over-optimistic about the amount of leisure that he will have, and therefore exaggerate the value of having more channels on the package. Likewise, a consumer who considers buying car insurance may falsely believe that he has below-average accident risk.
2 Over-confidence. The consumer may over-estimate the precision with which he estimates his second-period valuation of various consumption decisions. For instance, a consumer who is about to sign up for mobile phone services considers evidence from past consumption (his own and others’) and reaches an estimate that he will demand 1,000 minutes of airtime, with little uncertainty around this estimate. In reality, his demand for airtime will vary more than he anticipates.

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