Competitive Markets with Imperfectly Discerning Consumers

TL;DR

This paper models markets with consumers who have imperfect information and use subjective inference to deduce hidden charges, revealing unique equilibrium behaviors and responses to shocks that differ from rational expectations.

Contribution

It introduces a novel market model where consumers infer hidden charges from prices using subjective models, leading to a new characterization of equilibrium with unique properties.

Findings

Equilibrium prices can be fully revealing despite consumers' private information.

Market responses to shocks can display patterns impossible under rational expectations.

The equilibrium is characterized by a Bellman equation linking prices, charges, and welfare.

Abstract

We develop a market model in which products generate state-dependent potential hidden charges. Firms differ in their ability to realize this potential. Unlike firms, consumers do not observe the state. They try to infer hidden charges from market prices, using idiosyncratic subjective models. We show that an interior competitive equilibrium is uniquely given by what is formally a Bellman equation. We leverage this representation to characterize equilibrium headline prices, add-on charges and welfare. Market responses to shocks display patterns that are impossible under rational expectations. For example, equilibrium prices can be fully revealing and yet vary with consumers' private information.