Economics Research Seminar

“Naive Consumers and Financial Mistakes”

Financial contracts are complicated and consumers often do not grasp them in their entirety. This may lead to financial mistakes when borrowers do not fully internalize the cost of credit. We develop a quantitative framework that incorporates both sophisticated and naïve borrower behavior in a model of unsecured credit and equilibrium default. Borrowers select contracts that balance interest rates and penalty fees which make financial shocks - such as late payments or overdrawing - costly. While sophisticated borrowers correctly anticipate penalty fees, naïve borrowers face a higher risk without internalizing this fact. Thus, they make financial mistakes by choosing inefficiently high penalty fees. In equilibrium, penalty fees paid by naïves cross-subsidize interest rates for sophisticates. We use this framework to study consumer protection policies aimed at reducing financial mistakes such as borrowing limits, and also two unexplored features of the CARD act: transparency requirements and penalty fee limits. More transparency makes financial contracts easier to understand, reducing the financial risk for naïve borrowers. Thus, naïves pay lower penalty fees. Fee limits directly ban high-fee contracts for everyone. Both policies reduce the expected revenue from naïve fee payments and consequently interest rates rise. In both cases, naïves make fewer financial mistakes and enjoy a welfare gain. Sophisticates, in contrast, suffer: Since naïves pay lower fees, sophisticates lose cross-subsidization and experience welfare losses.