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Behavioral Biases and Consumer Credit Markets

posted by Oren Bar-Gill

Bob promised that I will talk about "behavioral biases that affect consumer credit markets."  Since I don't want to disappoint anyone, let me say a few words about this subject.  You don't have to be a psychologist (I am not a psychologist) to recognize that consumers are subject to biases and that biases affect markets, specifically credit markets.  Myopic consumers underestimate how much they will borrow on their credit card.  Optimistic consumers underestimate the likelihood of suffering financial hardship that will make it difficult to repay mortgage debt, credit card debt or any other type of debt.  Etc'.  Biases, and mistakes more generally, reduce consumer welfare.  No surprise so far. 

What is more interesting to me is the interaction between consumer mistakes and market forces (perhaps this is because I am an economist).  How do markets respond to consumer mistakes?  How do sophisticated sellers and lenders on the supply side of the market respond to biases and mistakes on the demand side of the market?  Such responses are common.  Rebate pricing responds to consumer overestimation of the likelihood of rebate redemption.  Low printer prices and high ink prices respond to underestimation of printer and ink use.  And credit card teaser rates respond to consumers' underestimation of the likelihood that they will stick around long enough to pay the high post-introductory rates.  (I should emphasize that these pricing schemes can also be explained within a no-mistake, rational choice framework; but, as I argue elsewhere, these alternative explanations are only partially successful.)

Market reactions to consumer mistakes are interesting in their own right.  But my interest in them is mainly functional.  First, market reactions to consumer mistakes often exacerbate the welfare costs of mistakes.  Second, market reactions provide evidence for the persistence of consumer mistakes.  This merits some elaboration.  That consumers make mistakes is self-evident.  But the persistence of these mistakes in any given market is far from evident.  Consumers learn from their mistakes and sellers often have powerful incentives to correct consumer mistakes.  Accordingly, an important question is whether the mistake persists, since only a persistent mistake can justify legal intervention.  And since mistakes are often difficult to observe and measure directly, looking at market reactions to these mistakes provides an indirect way to identify the mistakes.  In a sense, this is an example of the researcher delegating a research task to the market.  If I can't tell whether a mistake is robust and persistent in a given market context, I'll simply ask the market.  Sellers will only respond to mistakes that are sufficiently robust and persistent.  And seller responses, specifically pricing strategies, are generally much more readily observable than the underlying mistake.

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