On the benefits of being naive: the choice of contract duration with projection bias
Résumé
Empirical evidence shows that consumers are often subject to a projection bias,
such as they exaggerate the degree to which their future tastes will resemble their
current ones. Such biases are particularly acute when consumers commit to a longterm
contract. This paper aims at assessing the consequences of projection bias and
at defining when a legal intervention is relevant. In this perspective, we compare
the situation of naive and sophisticated agents, both with and without regulation
regarding contract duration and early termination fees. The demand side of the
market consists either of sophisticated agents, who perfectly anticipate their future
willingness to pay (WTP); or of naive consumers, who exhibit a projection bias.
The supply side is a monopoly offering long- and short-term contracts. Our main
contribution consists in showing that naive consumers are not always worse off than
sophisticated agents. The key parameter is how willingness to pay varies over time.
If consumers have an increasing WTP for a given service or product, naive agents
can actually be better off than sophisticated ones. We argue that naivete protects
consumers against a price increase. However, naivete also leads to less exchanges on
the market, thus generating a deadweight loss. Hence, the overall effect of naivete
on social welfare is ambiguous. As far as public policy is concerned, we conclude
that regulating contract duration is only relevant in some circumstances, depending
on the market characteristics and on the bias.