Welfare improving discrimination based on cognitive limitations

This paper is concerned with the situation in which a profit-maximizing monopolist faces consumers that are heterogeneous in two dimensions: their taste for quality and their level of cognitive limitations. The behavioral phenomenon considered here is the attraction effect when choices are made across categories. Using the standard second-degree price discrimination model, the optimal menu of contracts is characterized. Discriminating consumers based on their taste and cognitive limitations allows the monopolist to partially relax the incentive compatibility constraints. The decrease in distortion caused by the reduction of information rents moves the economy towards the efficient outcome. The optimal contract does not only increase the monopolist׳s profit but also improves the aggregate welfare of the economy. Furthermore, it provides a possible explanation for the apparent puzzle why one may observe that the same quality products are priced differently under different labels.