Journal Article

Contracting with Diversely Naive Agents

Kfir Eliaz and Ran Spiegler

in The Review of Economic Studies

Published on behalf of Review of Economic Studies Ltd

Volume 73, issue 3, pages 689-714
Published in print July 2006 | ISSN: 0034-6527
Published online July 2006 | e-ISSN: 1467-937X | DOI: http://dx.doi.org/10.1111/j.1467-937X.2006.00392.x
Contracting with Diversely Naive Agents

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In standard contract-theoretic models, the underlying assumption is that agent types differ in their preference or cost parameters, and the principal's objective is to design contracts in order to screen this type. We study a contract-theoretic model in which the heterogeneity among agent types is of a “cognitive” nature. In our model, the agent has dynamically inconsistent preferences. Agent types differ only in their degree of “sophistication”, that is, their ability to forecast the change in their future tastes. We fully characterize the menu of contracts which the principal offers in order to screen the agent's sophistication. The menu does not exclude any type: it provides a perfect commitment device for relatively sophisticated types, and “exploitative” contracts which involve speculation with relatively naive types. More naive types are more heavily exploited and generate a greater profit for the principal. Our results allow us to interpret real-life contractual arrangements in a variety of industries.

Keywords: D82; D86

Journal Article.  13734 words.  Illustrated.

Subjects: Information, Knowledge, and Uncertainy

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