Competitive Markets and Boundedly Rational Expectations

We analyze the trade of differentiated products when firms set both base and potentially hidden add-on prices. Boundedly rational consumers are subject to coarse reasoning and mistakenly believe that their action (product choice or substitution effort) has no effect on the probability of paying add-on prices. However, all consumers correctly anticipate their equilibrium expenses, so there are no “surprise charges.” Shrouding equilibria with inef ficient trade exist in this setting, but only if the market is sufficiently competitive. There exists an optimal maximal add-on price that defines the scope for profitable exploitative innovation. Further, the presence of boundedly rational consumers can generate innova tion incentives that improve welfare relative to the rational consumer benchmark. For credit/debit card markets the model explains why informational interventions often have only small effects on behavior, while add-on price regulation increases consumer surplus.