Exploiting Naïvete about Self-Control in the Credit Market

Heidhues, Paul; Kőszegi, Botond

doi:10.1257/aer.100.5.2279

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American Economic Review: Vol. 100 No. 5 (December 2010)

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Exploiting Naïvete about Self-Control in the Credit Market

Article Citation

Heidhues, Paul, and Botond Kőszegi. 2010. "Exploiting Naïvete about Self-Control in the Credit Market." American Economic Review, 100(5): 2279-2303.

DOI: 10.1257/aer.100.5.2279

Abstract

We analyze contract choices, loan-repayment behavior, and welfare in a model of a competitive credit market when borrowers have a taste for immediate gratification. Consistent with many credit cards and subprime mortgages, for most types of nonsophisticated borrowers the baseline repayment terms are cheap, but they are also inefficiently front loaded and delays require paying large penalties. Although credit is for future consumption, nonsophisticated consumers overborrow, pay the penalties, and back load repayment, suffering large welfare losses. Prohibiting large penalties for deferring small amounts of repayment—akin to recent regulations in the US credit-card and mortgage markets—can raise welfare. (JEL D14, D18, D49, D86)

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Authors

Heidhues, Paul (ESMT European School of Management and Technology GmbH, Berlin)
Kőszegi, Botond (U CA, Berkeley)

JEL Classifications

D14: Personal Finance
D18: Consumer Protection
D49: Market Structure and Pricing: Other
D86: Economics of Contract: Theory