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Heidhues, Paul; Köszegi, Botond; Murooka, Takeshi (2017): Inferior Products and Profitable Deception. In: Review of Economic Studies, Vol. 84, No. 1: pp. 323-356
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We analyse conditions facilitating profitable deception in a simple model of a competitive retail market. Firms selling homogenous products set anticipated prices that consumers understand and additional prices that naive consumers ignore unless revealed to them by a firm, where we assume that there is a binding floor on the anticipated prices. Our main results establish that "bad" products (those with lower social surplus than an alternative) tend to be more reliably profitable than "good" products. Specifically, (1) in a market with a single socially valuable product and sufficiently many firms, a deceptive equilibrium-in which firms hide additional prices-does not exist and firms make zero profits. But perversely, (2) if the product is socially wasteful, then a profitable deceptive equilibrium always exists. Furthermore, (3) in a market with multiple products, since a superior product both diverts sophisticated consumers and renders an inferior product socially wasteful in comparison, it guarantees that firms can profitably sell the inferior product by deceiving consumers. We apply our framework to the mutual fund and credit card markets, arguing that it explains a number of empirical findings regarding these industries.