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Behavioral Theory and Economic Applications

Final Report Summary - BEHAVIORAL THEORY (Behavioral Theory and Economic Applications)

The project boasts several major research achievements.
Perhaps the most successful research agenda in this project is on deceptive products. Our goal in this research agenda, all of which is joint with Paul Heidhues and some of which is also joint with Takeshi Murooka, is to explore some implications for market outcomes and policy of the possibility that consumers misperceive certain aspects of products. We build on and contribute to a growing theoretical literature that investigates how firms exploit naive consumers by charging hidden or unexpected fees, but we ask several important questions not considered by previous researchers, substantially deepening our understanding of markets for deceptive products.
To appreciate some of our insights, it is perhaps useful to step back and recall the classical economics view of markets. In this view, market competition helps consumers through lower prices, product offers that fit consumers’ needs, innovation that makes products better for consumers, and the provision of information that is useful for consumers in making decisions. We find that when there is a possibility that consumers misperceive products, markets work very differently. Instead of firms selling the best products, they have a tendency to sell, make the most profits on, and hence push, inferior products even when superior products are available. Instead of firms looking to innovate useful products, they have an incentive to engage in “exploitative innovations,” i.e. innovations that make products even more difficult to understand. Unfortunately, neither do firms help consumers understand what is going on through information provision. And our framework has novel implications for the recent debate on consumer information and privacy. We initiate the study of naivete-based discrimination, the idea that firms make individualized product offers based on information regarding consumers’ naivete. And the welfare effect of deception in these markets can be astronomical.
One recognition of our work in the area of deceptive products is that Paul Heidhues and I were asked to write a major review on Behavioral Industrial Organization for the Handbook of Behavioral Economics.
While originally conceived as part of our research agenda on deceptive products, we also developed, jointly with Paul Heidhues and Philipp Strack, a now distinct research agenda on “misdirected learning.” The received wisdom from classical economic models, and even in behavioral economics, has been that when a person has incorrect beliefs about something, then learning from relevant observations will lead his beliefs closer to the truth. In our work, instead, we identify a major general insight, that when a person has wrong preconceptions, then “learning” from his observations may lead him not to unlearning the preconceptions, but to forming further misconceptions, and to performing worse and worse. We explored this mechanism in detail in an important setting, overconfidence – when a person has unrealistic views of his ability or prospects. Our paper is an early contribution to a literature on misdirected learning that appears to be gaining momentum, and that we are also hoping to contribute much more to.
Jointly with Adam Szeidl, we have developed a new model of focusing in economic choices. It has long been recognized by behavioral and many other economists that individuals have limited and imperfect attention, and how they use this resource affects economic behavior. Models that are useful for economic applications, however, have been scarce. Ours is an early contribution to a growing recognition that studying attention from an economics perspective is both possible and important. We develop a tractable framework based on the idea that a person focuses more on, and hence overweights, attributes in which her options differ more. This insight allows us to shed new light on a number of settings, most importantly choice over time, a heavily researched area in which we explain puzzling patterns in behavior.