1 Overconfident Consumers in the Marketplace

When 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 assumes that consumers have rational expectations. Like assuming risk neutrality, assuming rational expectations is often expedient, drastically simplifying models and eliminating the need to measure beliefs. Yet consumer beliefs often deviate substantially from rational expectations, and a large literature in psychology shows that they are often wrong in systematic ways. This has important consequences for contract design, firm profits, and consumer welfare. The term overconfidence is used broadly in the psychology literature, referring to both overoptimism and overprecision. Overconfident consumers who exhibit overoptimism overestimate their own abilities or prospects, either in absolute terms or in relative terms (the above average effect). Overoptimism can cause consumers to missforecast their average futur