Dynamic competition in deceptive markets

Abstract

In many deceptive markets, firms design contracts to exploit mistakes of naive consumers. These contracts also attract less profitable sophisticated consumers. I study such markets when firms compete repeatedly and gather usage data about their customers which is informative about the likelihood of a customer being sophisticated. I find that in sharp contrast to a model with only rational consumers, this customer information is of great value to its owner despite perfect competition. Formally, I introduce a two-period model in which all consumers are aware of a transparent price component. Naives additionally pay a hidden fee, e.g. for an add-on service, that they do not take into account. Competing firms cannot discriminate between new consumers, but in period 2 can employ their private information to offer type-dependent contracts to their first-period customer base. I find that in period 2, firms offer a transparent discount to continuing naives but not to sophisticates, thereby making the less profitable sophisticates more prone to switch to poaching competitors. Uninformed competitors therefore adversely attract unprofitable sophisticates, leading them to compete less vigorously. This allows firms to earn positive margins on continuing naives, while breaking even on sophisticates. Since the adverse attraction of sophisticates mitigates competition, margins from naives increase in the share of sophisticates and firms prefer an even mix of both customer types. I also show that if firms can educate (some) naives about hidden fees, competition is already mitigated when firms compete for customers in the first period with symmetric information. Intuitively, firms coordinate prices in period 1 to prevent education in period 2. As a result, total profits increase already before firms learn about their customers’ naivete. I analyze a policy that discloses customer information to all firms and thereby increases consumer surplus, and illustrate the robustness of results through several extensions.