How Much Irrationality Does the Market Permit?

This article asks whether competition can ameliorate the consequences of cognitive error. Consumers differ cognitively, some being more prone to err (the "naive") than others (the "sophisticated"). Competition among firms is analyzed with a search equilibrium model. Firms offer an exploitative contract or a naive contract to a consumer population partitioned in two ways: some consumers are sophisticated while others are naive, and some consumers search for preferred contracts while others visit one firm. There are two principal results. First, when consumers shop, neither contract type is priced monopolistically, and competitive pricing sometimes obtains. Second, when enough consumers are sophisticated and the naive have a relatively low willingness to pay for their preferred contract, exploitative contracts decline in frequency and may actually vanish. These results suggest that while decision makers should continue to ask if consumers suffer from cognitive error, they also should ask whether markets do, or could be helped to, ameliorate error's consequences. (c) 2008 by The University of Chicago. All rights reserved.