Overconfident Consumers in the Marketplace

W hen consumers sign contracts, expectations about future usage of the product or service matter. For instance, the value provided by car insurance depends on how likely a consumer believes she is to file a claim; the value provided by a gym membership depends on how often a consumer anticipates going to the gym; and the value provided by a cellular phone contract depends on how many gigabytes of data a consumer anticipates using. The standard modeling paradigm makes the expedient assumption that consumers have rational expectations. Imposing rational expectations drastically simplifies models and eliminates the need to directly measure beliefs as they coincide with the distribution of observed outcomes. Yet a large literature shows that consumer beliefs often deviate substantially from rational expectations in systematic ways. This has important consequences for contract design, firm profits, consumer welfare, and public policy. The term overconfidence is used broadly in the psychology literature, referring to both overoptimism and overprecision. Overoptimistic individuals overestimate their own abilities or prospects, either in absolute terms or in comparison to others. In contrast, overprecise individuals place overly narrow confidence intervals around forecasts, thereby underestimating uncertainty. These biases can lead consumers to misforecast their future product usage, or to overestimate their abilities to navigate contract terms. In consequence, consumer overconfidence causes consumers Overconfident Consumers in the Marketplace