Competitive Markets with Imperfectly Discerning Consumers

We develop a market model in which products generate state-dependent potential hidden charges. Firms differ in their ability to realize this potential. Unlike firms, consumers do not observe the state. They try to infer hidden charges from market prices, using idiosyncratic subjective models. We show that an interior competitive equilibrium is uniquely given by what is formally a Bellman equation. Using this representation, we show that relative to rational expectations, add-on charges are lower whereas headline prices and social welfare are higher. Market responses to shocks display patterns that are impossible under rational expectations. For example, although fully revealing, equilibrium prices can vary with consumers’ private information.
(joint with Rani Spiegler)

Link to the paper

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