Warren on Rationality, Choice, and Regulation in the Credit Card Market

Josh Wright —  28 December 2006

Elizabeth Warren (Credit Slips) points to an interesting empirical study by Agarwal, Liu, Souleses, and Chomsisengphet (“ALSC”) which examines consumer credit card selection in a natural experiment setting in which a card company offers two cards to consumers: (1) a high interest rate, no annual fee card and (2) a low rate card with an annual fee. The results?

  • About 60% of consumers get the decision right with the benefit of hindsight
  • 40% do not make initially select the right card
  • Many of these initial errors are subsequently corrected as a result of consumer card switching, while ALSC report that “a small minority of consumers persists in holding substantially sub-optimal contracts without switching.”

Warren (also check out the comments to the post) asks whether “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?” Warren’s answer: is more regulation in light of what she describes as the “staggering” 40% error rate. Professor Warren writes:

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.

Heresy was not the first thought that came to my mind. Though I admit I am not quite sure what Warren has in mind in terms of undermining the claim that more choice is always good. Nonetheless, I don’t think this study undermines those assumptions at all. Quite the contrary, actually. While the burden of proof is on Warren and others advocating more regulation here to demonstrate that less choice would improve consumer welfare, not only does this study not satisfy the burden, I think a reasonable interpretation of the results cuts the other way. The results suggest that consumers making credit card contract decisions behave rationally, the initial error rate is not strong evidence of consumer irrationality in light of relative costs and benefits of card switching, and the error costs are very small.

A little context is necessary to make the case for this interpretation of the data, as well as the reporting of some key results in the ALSC paper that Warren does not discuss in her post but shed light on the question of consumer rationality in the credit card market. In light of these findings, discussed below the fold, I think it is pretty clear that these findings support a standard economic model of credit card borrowing.
First, and consistent with standard economic theory, the consumer error rate decreases in the cost of the error as well as the number of times a consumer makes the decision. In other words, consumers correct bad decisions with repeat play and perhaps most importantly, make fewer errors when stakes are higher. It is difficult to square these findings with models of irrational consumer behavior. As an aside, economic theory does not suggest that consumers are immune to errors! At the very least, an error rate that decreases in the cost of error is inconsistent with the simple behavioral/ consumer irrationality-based models of consumer behavior that frequent the legal literature. By the way, another empirical study using micro-level data on this and related questions (Brown & Plache (Paying with Plastic, 73 U. Chi. L. Rev. 63 (2006)) reaches very similar results concerning consumers’ abilities to select credit card contracts optimally and is a paper very much worth reading for those interested in this topic.

Second, what about the “staggering” magnitude of the social cost involved with the initial errors? Warren does not report that ALSC report that these error costs are generally bounded in magnitude by the size of the typically small annual fee (see Table 3, the median fee is $25). The most common “behavioral” call for regulation of the credit card market is the claim that unsophisticated users will be seduced by cards with low annual fees and higher interest rates, unknowing that this decision is sub-optimal ex post and incurring large chunks of debt at higher interests rates as a result. However, ALSC find that of those consumers in their panel that do not pay annual fees, the net annual error costs exceed $200 for only 225 out of over 64,000 no-fee accounts.

If one knew the credit card market only by reading the legal literature, the most staggering feature of the ALSC (and Brown & Plache) results would be shock at how often consumers are selecting contracts optimally, switching cards, minimizing error costs. To be sure, there are a very small margin of consumers who make persistent errors. But what are we to make of this group in the context of a decision where the costs of getting the decision “right” are, on average, bounded by the magnitude of the annual fee? How large are these costs relative to the costs of switching cards, or better yet, of regulation? Of the consequences (intended and otherwise) that regulation might have on these consumers?

So, do the ALSC findings support the inference that credit card consumers are irrational and in need of regulation or less choice? It appears not. After all, most consumers here are selecting cards optimally: i.e. they are better off because of their decision! Further, the cost of failing to do so is low, and yes, reducing consumer choice is likely to reduce welfare in this setting. If those advocating regulation here have a more nuanced view of these results that supports the view that prohibiting a menu of contracts would increase welfare, I would like to hear it. Note: my naive cost/benefit analysis also does not account for other obvious (and likely enormous) benefits of credit card spending versus cash or other payment forms for the large proportion of users that do not revolve debt.

Third, the relatively small error costs (and the fact that the majority of credit card users appear not to revolve balances at all) recast the 40% initial error rate in a different light in my view. If the expected benefit of card switching is small relative to search costs, it is not especially surprising that many consumers do not incur these costs. These findings, to me, suggest caution about overstating the magnitude of the effects of “consumer irrationality” in the credit card market.

As to Warren’s question of whether it would be helpful to reframe the policy question as something like: “why WOULD the provider offer multiple products but for the exploitation of consumer error?” No. I don’t think this reframing is helpful. It is the wrong policy question to be asking. Yes, we care about an explanation of why providers offer multiple products — but isn’t the dispositive question here whether regulation would improve welfare relative to the status quo net of the costs of regulation? Further, I can think of one obvious reason why the provider would offer multiple products just like multitudes of suppliers in other markets: consumer heterogeneity in demand for different credit card attributes.

Consumers who regularly revolve debt might want a different type of credit card than convenience users that pay off their debt every month and value different card attributes. Providers offer different products to different types of consumers because the consumers value different card attributes and consumers select cards accordingly. The ALSC results suggest that they do so pretty well, and it is well known that this sort of competitive price discrimination is generally welfare-enhancing.

In sum, these findings suggest that consumers generally behave rationally in the credit card market and select the optimal card. When they don’t do so initially, the probability of error in subsequent decisions decreases in the costs of error. In the context of a decision where the costs of errors are low, one should not necessarily be surprised at a high error rate. Persistent errors may well consist of “rational ignorance,” and it is a significant leap from high error rates to, as Warren puts it, “bring[ing] into question the assumptions that underlie the claim that more choice is always good.” The leap becomes much more daunting in light of the ALSC findings Warren does not report: error rates decrease in the size of the error and in experience with the decision. Sounds like fairly rational behavior to me.

5 responses to Warren on Rationality, Choice, and Regulation in the Credit Card Market

  1. 

    Well, I should have just listened to Josh and gone to the comments on Warren’s post to avoid re-inventing the wheel. The very first comment there already suggested exactly what I wrote above.

    I should also just start assuming that Warren’s real intent is to waste my time with her socialist musings.

  2. 

    Thanks. That makes more sense. So whether or not one chooses a ‘no fee’ card depends on one’s personal expected pattern of usage/payment (e.g., pay off each month vs. carry a balance)–as long as one has the choice, rather than the Soviet solution apparently favored by Ms. Warren.

    It seems that the threshold for deciding the economic efficiency of choice vs. no choice, then, isn’t how “high” the error rates are, but whether the degree to which ‘choice with errors’ is less costly for the users than the one-size-fits-all solution, whereby one group of card users would be penalized for not having the other option.

    Josh suggests that the total costs of ‘choice with errors’ may not be that high, and suggests that options are valuable based on consumer heterogeneity (which I think is still legal in Massachusetts). Again, not having read the study, it seems to me that this unforced option value is calculable based on the study’s results.

  3. 

    An error is the selecting the contract option that does not minimize total interest costs net of the fee.

  4. 

    I haven’t read the ALSC study, but am I to infer from your post that their study defines the “no fee option” as an “error” regardless of whether the user revolves debt or not? That wouldn’t seem logical.

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  1. TRUTH ON THE MARKET » Becker and Posner on “Libertarian Paternalism” - January 15, 2007

    […] But doesn’t this argument apply to all sorts of transactions? Is the literature on trans-fats and their long-term health effects all that different on these grounds from smoking, wine, red meat, soda, coffee, potato chips, or credit cards (and credit card consumers appear to be behaving quite rationally in their own interest)? The food items are not types where the costs of absorbing the information is “trivial” like the peanut oil label for the consumer with a peanut allergy. Instead, consumers frequently make tradeoffs associated with long-term health effects that appear to be quite complicated. And the rush of producers going trans-fat free without government intervention suggests at least that consumers are indeed responding to evidence of the harm from trans-fats. Becker’s response to Posner’s previous trans-fat post also contains citations to a literature suggesting that consumers respond rapidly to health news. And from Becker: Classical arguments for libertarianism do not assume that adults never make mistakes, always know their interests, or even are able always to act on their interests when they know them. Rather, it assumes that adults very typically know their own interests better than government officials, professors, or anyone else–I will come back to this. In addition, the classical libertarian case partly rests on a presumption that being able to make mistakes through having the right to make one’s own choices leads in the long run to more self-reliant, competent, and independent individuals. It has been observed, for example, that prisoners often lose the ability to make choices for themselves after spending many years in prison where life is rigidly regulated. […]