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Economic Model Almost Working or Broken?

posted by Elizabeth Warren

A growing body of research suggests that humans make decisions that are not entirely consistent with the picture of an economically rational actor (e.g., in an experiment, econ students spend more when they use credit cards than when they use cash).  A new study by Sumit Agarwal, Chunlin Liu, Nichaolas Souleses, and Souphala Chomsisengphet uses data from a credit card company that offered two cards:  one with a higher interest rate and no annual fee and a second with an annual fee and lower rate and the subsequent borrowing.  They then studied the paying behavior of the customers to test consumer rationality in this limited sphere.

Agarwal, et al, report that consumers get the right answer about 60% of the time--that is, those who borrow little or no money correctly take the no-fee card and those who borrow more money over a longer time correctly pay a fee and take the lower interest rate option.  Of those who make the sub-optimal choice, some make changes later (as the experiment permitted), but the net errors were substantial, costing many consumers hundreds of dollars even in this limited test.  Agarwal and colleagues note that "a small minority of consumers persists in holding substantially sub-optimal contracts without switching."  (I would report the percentages, but I can't quite figure them out from the table.)

Do these data support the notion legal policy can be shaped by the presumption of economic rationality, or do the data support a call for more regulation?  After all, a majority of consumers get the decision right, and an even larger majority get it right after they first lose some money.  On the other hand, a 40% error rate is pretty staggering, particularly in light of the authors' note that this is an "especially simple decision" that may have limited applicability in more complex decision making.

Would it help to frame the policy question is from the provider angle?  What's the point of offering two different products, except to hope that the number of consumer who get it wrong will exceed in dollar volume the number who get it right.  Or, from an informed consumers' perspective, perhaps the optimal system is one in which they make good decisions and hope for cross-subsidization from less-clever consumers who help keep credit cards highly profitable and easy to use in a variety of settings (e.g., grocery stores, cabs, pizza deliveries, etc.).

I realize it is heresy in many circles to ask if consumers should have fewer choices.  But at some point the empirical studies about high error rates bring into question the assumptions that underlie the claim that more choice is always good.


Elizabeth, one reason the provider offers multiple products may simply be to serve consumers better. We get cars in all sizes, shapes, and colors because we don't all like blue subcompacts. I agree that too many choices may not necessarily be a good thing, and the optimal number and complexity of choices might vary by product. My sense, though, is that with credit cards, the optimal number may be more than 2, not less (although probably less than the number that are currently floating around out there).

It would be interesting to compare the error costs consumers incurred in the experiment you cite with a world in which only one of the cards was available. It's not obvious to me why costs would be smaller in this latter situation. Moreover, with no choice--i.e., a one-size-fits-all approach--consumers might change their borrowing behavior because of the constraints of a bad fit, but it's not clear they're better off. And in any event, debt NOT incurred may be difficult to measure.

One last point: without having read the paper and the contours of the experiment, I'm not sure that failing accurately to predict one's own future borrowing/spending behavior ex ante is necessarily a sign that a "mistake" was made or that regulation is necessary. People change their minds all the time. This could be irrational. Or it could be rational--a consumer may simply be responding to new information or changed circumstances.

Fred, I understand the tilt toward choice. But the difference between blue subcompacts and red SUVs is not the same as the difference between daily compounding and monthly compounding.

Money is the ultimate fungible good. I'm trying, perhaps inartfully, to grope my way toward another question: If differences a credit card company offers are merely bets that some consumers will make prediction errors (or math errors or other kinds of cognitive errors), then what is the social utility in providing that "choice"?

And that is the question, are the different plans different just for the sake of being different. In this paper, the two plans offered a real choice: no annual fee in exchange for higher interest rates. This is not an issue of monthly versus daily compounding, which offers no benefit. This saves money for those who rarely use the credit and know they won't need it.

It turns out, a majority of consumers made the right (ex post) decision. And the wrong decisions were mostly cheap. A substantial majority of wrong decisions (76%) were those who incorrectly chose to pay an annual fee, thus limiting their losses to the annual fee. Only 1,707 out of the dataset of 150,050 lost more than $100 annually by making the wrong decision; all of them incorrectly not paying the annual fee. A lot of people chose not to think about the problem and just forked over the annual fee whether they would need the cheaper credit or not.

This sounds like a rational decision. It probably costs more than $25 (median fee) of your time to figure out whether you will save more than $25 with a lower interest rate. For those for whom the decision was obviously important (more than $100 savings by paying the annual fee), 85% (1707/11427) made the right call. It is difficult to fault the people who paid the annual fee but did not end up using their cheaper credit. Their ex post decision was certainly incorrect, but it is not at all clear their ex ante decision was.

The shocking part of the data is that among wealthy accounts ($5000+ in liquid assets, $25000 in total assets) that were heavy borrowers (more than $100 in savings from paying the annual fee) a majority (341/604) made the wrong decision and did not pay the annual fee. Presumably they did not expect to be borrowing on credit.

Overall, it sounds like an economic model that is almost working.

Actually, the decision to take the card with the annual fee is not necessarily irrational. One of the most cold-bloodedly rational men I know, who pays off his card every month without fail, has a card with an annual fee and a lower interest rate. His reasoning is that right now, when his life is pretty much on track and he can afford to pay off his credit card every month, the annual fee is not much of a burden to him. On the other hand, if he gets into trouble and actually needs the credit, the lower interest rate could be a huge deal. (Of course, he may not have factored in that his interest rate may go up substantially if his financial situation changes.)

(Looking over previous comments, I see that this is really the human face of Archit's third paragraph.)

Elizabeth, I think this study is consistent with consumer irrationality, but it could also be read as an example of consumers making rational decisions based on faulty assumptions. That is the study basically confirms Oren Bar-Gill's argument that consumers systematically overestimate their ability to pay their credit card bills in full and on time. A consumer who thinks he will only transact and use float, not borrow, should never pay an annual fee, except to get some particular bundled benefit (rewards, insurance, etc.) I don't think this study proves that many consumers don't know how to choose between credit cards, only that they lack the information (their future income and expense flows) to make the right choice. Whether consumers are irrational or misinformed (or both), the results are the same, and that's the disturbing part. But irrationality or misinformation implicate different solutions. We can try to correct underestimations of future cost through proxies such as mandatory up-front costs. If consumers are truly irrational in their spending, proxy cost signalling will not be effective.

This study also shows why annual fees have disappeared. Consumers are willing to gamble. They'd rather pay nothing now and take a chance of paying a lot later. And like any good casino, the house always wins.


I think that your conclusion that this data suggests consumer “irrationality” is unfounded. The problem that I have with this study is simple, it is not properly employing the scientific method. Observation is necessary, but insufficient. Further, observation plus a main effect is necessary, but insufficient. This study was not designed to test a theory, it was designed to show that individuals do not always make "optimal" decisions. We all intuitively know that. Classical economists make assumptions about individual actors to model market behavior not individual behavior. We can entertain other economic theories to assess actor behaviors (e.g., Agency Theory or Game Theory).

The major limitation of this study is that we cannot rule out a multitude of potential explanations. A theory was not really tested in this study. The “attacking” of economic man is not a relevant null given that it is one of many assumptions to enable market predictions. Interestingly, at the market level the simplifying economic assumption is valid . We can review the choice literature and see that we have many potential theories/models to explore for hypotheses.

Before going to alternative theories it is probably worth starting with Simon’s notion of “bounded rationality” to frame the consumer task these authors attacked (and missed). Simon identified three factors that limit “perfect choice” - (1) incomplete information due to gathering time/costs, (2) processing requirements to search the state space of choice, and (3) incomplete/transitional objective function specification. We can see that the authors did not do a great job addressing all three factors. This would be accomplished by either experimental design or in this case finding cases where we can block for the three factors. The authors did not achieve this. They are thus left with a quasi-experimental design that has limited internal and construct validity. We thus cannot conclude much from the work beyond that it is an interesting characterization of a phenomena that we are all well acquainted with (either from BDT literature or personal experience).

In summary, I would be far less conclusive than you in asserting that the data demonstrates “irrationality” of the subjects (It may very well suggest “irrationality” of the authors and readers).

I was actually trying to find an email address for Elizabeth Warren who I heard on NPR a few weeks ago. When I saw this sight I figured I'd try to get my message to her here. Here goes...
For years I refused to use credit cards. A couple of years ago I decided to begin using one for business purchases. Last month I paid my bill, in full, on the due date, at the bank branch located across the street from my business. This month I got a bill with a late fee and interest charges. I was shocked because I always pay the balance in full and I knew I had paid the previous bill at the branch, in person, on the due date, as mentioned. When I called the 800 number (twice, because of a long hold and a disconnect) I was told that it can take up to 5 days for a branch payment to be credited to my credit card account. I asked the supervisor, in this age of computers, how long it would take for one branch to know that I had emptied my checking or savings account at a different branch. He admitted that the entire chain would know instantaniously that my account was empty and none of them would allow me to withdraw another penny. When I then asked why it was not the same for a credit card payment, he had no answer. He refused to drop the charges and I shredded the card with him listening. I just thought you would like this story. You were great on NPR.

To: Elizabeth Warren
Please contact me regarding researching Charles Albert Warren b. 1854 and Mary Ellen b. 1860.
We found a small picture of this couple and would love to get it to the right family.

Kitty Cortez
Rocklin, CA

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