Contract Design and Self-Control: Theory and Evidence∗

How do rational firms respond to consumer biases? In this paper, we analyze the profitmaximizing contract design of firms if consumers have time-inconsistent preferences and are partially naive about it. We consider markets for two types of goods: goods with immediate costs and delayed benefits (investment goods) such as health club attendance, and goods with immediate benefits and delayed costs (leisure goods) such as credit cardfinanced consumption. We establish three features of the profit-maximizing contract design with partially naive time-inconsistent consumers. First, firms price investment goods below marginal cost. Second, firms price leisure goods above marginal cost. Third, for all types of goods firms introduce switching costs and charge back-loaded fees. The contractual design targets consumer misperception of future consumption and underestimation of the renewal probability. The predictions of the theory match the empirical contract design in the credit card, gambling, health club, life insurance, mail order, mobile phone, and vacation timesharing industries. We also show that time inconsistency has adverse effects on consumer welfare only if consumers are naive. ∗We thank four exceptional referees, George Baker, Daniel Benjamin, Drew Fudenberg, Luis Garicano, Jerry Green, Oliver Hart, Caroline Hoxby, Markus Möbius, Daniele Paserman, Ben Polak, Andrei Shleifer, and in particular Philippe Aghion, Edward Glaeser, Lawrence Katz, and David Laibson. We received helpful comments from participants of seminars at the Econometric Society Summer Meeting 2001, AEA Meeting 2002, the Behavioral Public Finance Conference 2003, at Berkeley, Humboldt (Berlin), Bonn, BU, Harvard, Haas, INSEAD, Maryland (College Park), MIT, Northwestern, Stanford, Yale, and Zurich University. Nageeb Ali, Madhav Chandrasekher, Tricia Glynn, Boris Nenchev, and Christine Yee provided excellent research assistance. For financial support, DellaVigna thanks Bank of Italy and Harvard University, Malmendier thanks Harvard University and the German Academic Exchange Service (DAAD).