How Much Irrationality Does the Market Permit?

This paper asks whether market competition can ameliorate the effect of cognitive error. Competition is possible because consumers differ cognitively, some consumers being more prone to err (the quot;naivequot;) than others (the quot;sophisticatedquot;). The approach here is to create a search equilibrium model of a market with a large number of firms. Each firm can offer either an exploitative or a naive contract to a consumer population that differs along two dimensions: some consumers are sophisticated while others are naive; and some consumers search for their preferred contract while others visit one firm. There are two principle results. First, when consumers comparison shop, neither contract type is priced monopolistically and competitive pricing will sometimes obtain; hence, there is less redistribution from consumers to firms. Second, when a fair proportion of consumers are sophisticated and the naive have a relatively low willingness to pay for their preferred contract, competition reduces the incidence of exploitative contracts and may cause these contracts to vanish. These results suggest that while decision makers should continue to ask if consumers suffer from cognitive error, they also should ask whether the market is ameliorating the consequences of error or could be helped to do so