We develop a model of a competitive market for non-linear credit contracts, and analyze the contract choices, loan-repayment behavior, and welfare of sophisticated and non-sophisticated borrowers with a taste for immediate gratification. Consistent with many credit cards and subprime mortgages, the baseline repayment terms of a competitive-equilibrium contract are cheap, but they are also inefficiently front-loaded and delays require paying large penalties.Non-sophisticated borrowers tend to borrow too much despite credit being for future consumption, and then to both pay the penalties and repay in an ex-ante suboptimal back-loaded way, leading to welfare losses that are typically large. Prohibiting large penalties for deferring small amounts of repayment-akin to some recent new regulations in the US credit-card and mortgage markets-can raise welfare.Keywords: hyperbolic discounting, sophistication, partial naivete, screening, consumer protection, subprime markets, credit cards Researchers as well as policymakers have expressed concerns that some contract features in the credit-card and subprime mortgage markets may induce consumers to borrow too much and to make suboptimal contract and repayment choices. 1 These concerns are motivated in part by
We modify the Salop (1979) model of price competition with differentiated products by assuming that consumers are loss averse relative to a reference point given by their recent expectations about the purchase. Consumers' sensitivity to losses in money increases the price responsiveness of demand—and hence the intensity of competition—at higher relative to lower market prices, reducing or eliminating price variation both within and between products. When firms face common stochastic costs, in any symmetric equilibrium the markup is strictly decreasing in cost. Even when firms face different cost distributions, we identify conditions under which a focal-price equilibrium (where firms always charge the same “focal” price) exists, and conditions under which any equilibrium is focal. (JEL D11, D43, D81, L13)
We study competitive market outcomes in economies where agents have other-regarding preferences. We identify a separability condition on monotone preferences that is necessary and sufficient for one's own demand to be independent of the allocations and characteristics of other agents in the economy. Given separability, it is impossible to identify other-regarding preferences from market behavior: agents behave as if they had classical preferences that depend only on own consumption in competitive equilibrium. If preferences, in addition, depend only on the final allocation of consumption in society, the Second Welfare Theorem holds as long as an increase in resources can be distributed such that all agents are better off. Nevertheless, the First Welfare Theorem generally does not hold. Allowing agents to care about their own consumption and the distribution of consumption possibilities in the economy, we provide a condition under which agents have no incentive to make direct transfers, and show that this condition implies that competitive equilibria are efficient given prices.
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