Saturday, March 11, 2006
I'm teaching a short course on the economics of contract law at the Faculty of Law of the University of Ghent, Belgium, for a couple of weeks. One of the things that I asked the students to read and discuss is Oren Bar-Gill's article "Seduction by Plastic," 98 Nw. L. Rev. 1373 (2004). I very highly recommend the article. It is so rich that I can only do violence by trying to summarize it, but here goes.
The market for issuing credit cards to consumers in the U.S. is extremely competitive. The average American household has 14 credit cards and makes more than $1,000 in purchases per month by means of credit cards. Since 1995 the volume of credit card purchases has exceed that done by cash.
Notwithstanding the high degree of competition, there are significant and systematic deviations from marginal cost in credit card pricing. Speaking very broadly, the price for a card during its early use by a particular consumer is below marginal cost, and the price for the card later in its use by that same consumer is much higher. The puzzle that Bar-Gill seeks to explain is how there can be so much competition in the credit-card-issuing market and such significant and systematic deviations from marginal cost. The answer is that consumers suffer from some predictable behavioral biases that allow issuers to exploit them. Specifically, consumers are overoptimistic about their abilities to pay down their balances in the future. Oren puts this the other way around: consumers underestimate their future borrowing needs. The key for issuers is, therefore, to sign up as many users as possible -- hence the low initial rates -- so as to take advantage of the fact that later, consumers will run up large balances and not pay them down quickly.
I leave for your own reading Oren's discussion of the possible policy correctives. He's not sanguine about the ability of law to make corrections, and I think that he's right.
In the discussion with the students here in Ghent, there were several fascinating things that came up. The Europeans were astonished by the breadth of U.S. credit card use. Most of them contend that they have (and that their families have) only one credit card and that they find it inconceivable that they'd not pay off the entire balance each month. Even more interesting was the claim by a former Pakistani judge that in his country lawyers, judges, and police are not allowed to have credit cards on the theory that they will run up large balances and then find legal or high-pressure ways to avoid paying off those balances.