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Optimal Contracts with Heterogeneously Boundedly Rational Consumers

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Keywords: Bounded Rationality, Context Effects, Contract Design, Marketing.

This paper studies the situation in which consumers are heterogeneously boundedly rational and characterizes the optimal contract for a profit-maximizing monopolist. The bounded rationality considered here is due to context-effects bias. This is a type of cognitive limitation that prevents agents from making context-independent decisions and therefore, leads to the violation of the independence of irrelevant alternatives axiom. Each consumer is affected differently from this limitation, i.e., consumers are diversely context-biased. Using the standard second-degree price discrimination model, we characterize the optimal menu of contracts and show that the seller can exploit consumers' bounded rationality and increase his profit. Our main result is that the optimal contract has either two or three menus depending on the distribution of the parameter θ measures the strength of context-effects bias. The contract with two menus discriminates consumers based only on their preferences, whereas the contract with three menus partitions the consumer set into three subsets based on their preferences and the level of context-effects bias. The latter contract provides a possible explanation to the apparent puzzle why one may observe products of the same quality sold at different prices under different labels.

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