Working Paper: NBER ID: w28121
Authors: Hanming Fang; Zenan Wu
Abstract: A wealth of evidence shows that individuals are biased and firms can often exploit consumers' behavioral biases in their contract designs. In this paper, we study how vulnerable biased individuals are to their own behavioral biases in market equilibrium, and focus on the role of risk aversion and intertemporal elasticity of substitution (IES). We measure consumer vulnerability by the percentage loss in a consumer's equilibrium certainty equivalent from a market with non-biased consumers to that with biased ones. We examine several important behavioral biases that have been extensively studied in the literature, including the impact of biased beliefs (either over- or under-confidence) in an insurance market, the impact of present bias and naïveté about present bias in a dynamic model of credit contract design, the impact of projection bias about habit formation, and the impact of expectation-based loss aversion on an investor's portfolio choice. We show that consumer vulnerability to all four commonly studied behavioral biases has a non-monotonic relationship with risk aversion or IES. This is in striking contrast to the deviations in the equilibrium allocations from the rational benchmark, which are often monotonic to the risk aversion or IES. We also consider a setting of biased agents with Epstein-Zin preferences to isolate the effect of risk aversion from that of IES.
Keywords: No keywords provided
JEL Codes: D60; D81; D86; D91
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Consumer vulnerability (D18) | Welfare losses (D69) |
| Consumer vulnerability (D18) | Risk aversion (D81) |
| Risk aversion (D81) | Consumer vulnerability (D18) |
| Intertemporal elasticity of substitution (IES) (D15) | Consumer vulnerability (D18) |
| Risk aversion (D81) | Welfare losses (D69) |
| Intertemporal elasticity of substitution (IES) (D15) | Welfare losses (D69) |
| Consumer vulnerability (D18) | Insurance coverage (G52) |
| Biased beliefs (D91) | Insurance coverage (G52) |
| Consumer vulnerability (D18) | Overconfidence (D83) |
| Overconfidence (D83) | Welfare losses (D69) |