ABSTRACT
It is standard in economics to assume that individual beliefs are accurately calibrated to reality. But if actual beliefs deviate from this standard assumption, then profit-maximizing firms and welfare-maximizing governments may find it advantageous to adjust their contracts and policies. Firms can exploit the nonstandard beliefs of employees and consumers for profit by complicating contracts. And public policies designed to mitigate individual welfare losses must take into account both actual beliefs and firm responses. This chapter explores these issues. It begins with a discussion of welfare when beliefs are nonstandard. The first application concerns overconfident employees. In this case, overconfidence can help to explain the practice of paying stock options to rank-and-file workers. The chapter then turns to features of exploitative contracts, including three-part tariffs, memory hurdles, and attention hurdles. The final topic is the design of optimal social insurance, with applications to unemployment and health insurance.
