On the benefits of being naive: the choice of contract duration with projection bias

Empirical evidence shows that consumers are often subject to a projection bias,such as they exaggerate the degree to which their future tastes will resemble theircurrent ones. Such biases are particularly acute when consumers commit to a longtermcontract. This paper aims at assessing the consequences of projection bias andat defining when a legal intervention is relevant. In this perspective, we comparethe situation of naive and sophisticated agents, both with and without regulationregarding contract duration and early termination fees. The demand side of themarket consists either of sophisticated agents, who perfectly anticipate their futurewillingness to pay (WTP); or of naive consumers, who exhibit a projection bias.The supply side is a monopoly offering long- and short-term contracts. Our maincontribution consists in showing that naive consumers are not always worse off thansophisticated agents. The key parameter is how willingness to pay varies over time.If consumers have an increasing WTP for a given service or product, naive agentscan actually be better off than sophisticated ones. We argue that naivete protectsconsumers against a price increase. However, naivete also leads to less exchanges onthe market, thus generating a deadweight loss. Hence, the overall effect of naiveteon social welfare is ambiguous. As far as public policy is concerned, we concludethat regulating contract duration is only relevant in some circumstances, dependingon the market characteristics and on the bias