The Volokh Conspiracy

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"Consumer Credit and the American Economy," Part 3: Behavioral economics analysis of consumer credit use


This essay continues a short review of some ideas discussed at greater length in Consumer Credit and the American Economy, a new book by Thomas A. Durkin, Gregory Elliehausen, Michael E. Staten, and Todd J. Zywicki (Oxford University Press, August, 2014). The first essay examined economic reasons why consumer credit use is widespread and the second the question whether consumer credit use is excessive. This essay looks at evidence of psychological influences on the economics of consumer credit use.

Behavioral Analysis and Consumer Credit Use

During the post-World War II period, the view that consumer credit use is a normal development in a modern economy seems to have gained traction with the public at large. In large part, this new view is likely a result of decades of experience with consumer credit that has demonstrated its usefulness. There are risks with consumer credit, to be sure, but most middle-class consumers do not have serious credit troubles, and they apparently view credit availability reasonably favorably.

Widespread acceptance of consumer credit is observable from public opinion surveys. Surveys also show that consumers appear well able to differentiate in their minds among acceptable purposes for borrowing; some purposes are more acceptable than others and have been so for a long time. These views suggest a degree of thoughtfulness and deliberation in credit decisions, but this kind of differentiation also suggests that consumers' analyses of their credit decisions may not be entirely consistent with a strict interpretation of economists' axioms of rational choice. Instead, these views suggest that when making credit decisions, consumers may use heuristics ("rules of thumb") that simplify decision making or employ some kind of mental accounting or sorting for making distinctions. Such behavior may be purposive, intelligent, and utility enhancing but still fall something short of the extensive weighing of alternatives underlying the economic model of utility maximization. This fact alone encourages further consideration of the underlying psychological conditions for consumers' choices.

Development of psychological aspects of the theory of consumer credit demand falls into two broad categories: (1) analyses based on psychologists' models of the cognitive process and (2) economic hypothesizing about credit use based on assumptions about consumers' cognitive biases. Analyses in the first category are largely empirical and provide insights into the processes that lead to economic decisions. Analyses in the second category have generated many recent theoretical discussions, mostly about credit card use, but to date have produced relatively few empirical generalizations about consumers' credit or credit card use behavior. Nonetheless, they form a new genre of consumer credit analyses in recent years. A prominent subset of theories in the second category called "Behavioral Law and Economics" (BLE), appears to be mostly concerned with implications of suggested cognitive biases for legal and policy prescriptions, rather than development of either theory or empirical evidence per se. As discussed in a previous essay, some consumers may sometimes behave psychologically irrationally in their use of credit cards, but BLE should provide better empirical evidence of frequency and quantity before recommending legal changes to a system used successfully by millions of patrons. Only a little more about the offshoot BLE will be said here.

Actually, behavioral economists and psychologists have studied consumers' credit decisions for decades, especially using consumer survey techniques. Their studies have been empirical, and many are concerned with the extent to which consumers' behavior is rational. Standard economic theory is concerned with specific goals such as utility maximization, evaluation of all available alternatives, choice of the alternative that best achieves the goal, and consistency in choice. In contrast, behavioral economists expand this concept of rationality. They view rational behavior as purposive and deliberative but not necessarily strictly optimal. They note that consumers often simplify, taking shortcuts and using "rules of thumb." Consumers are often satisfied to take small steps toward goals (adaptive and satisficing behavior) rather than making the effort to achieve the optimum. Culture, group membership, attitudes, past experience, and even biases may influence the decision process.

Survey research on the process of spending in large part supports the economic analyses that treat consumer credit as a part of consumers' investment-consumption decisions. Surveys have found that the bulk of consumer credit arises in the process of purchasing household durable goods and services that do not fit conveniently into monthly budgets. Consistent with the theories of the economists, surveys find that credit use is greatest in early family life cycle stages, particularly in families with young children. Such families typically start with relatively low stocks of durables and can often obtain high rates of return on additional household investments.

A major additional focus of the survey research has been to investigate the extent to which consumers' durable goods purchasing and financing decisions are deliberative and rational. The research indicates that few purchases include all of the elements of rational decision making, namely, planning for purchases, extensive search for information, formulation of evaluation criteria, and careful consideration of alternatives before making decisions. As indicated, consumers often simplify, take shortcuts and use rules of thumb (heuristics). Consumers may focus on one or a few product characteristics or rely on the experience of friends, for example. Nevertheless, evidence suggests that most consumers use one or more elements of deliberative behavior in decisions about consumer durables and credit.

The research identified several circumstances that lead to more or less deliberation in durable goods purchases. Situations in which consumers tend to follow more closely the economists' fuller model of rational decision making include purchase of an item that is considered expensive or particularly important, purchase of a new or unfamiliar product, dissatisfaction with a previous purchase, and a strong new stimulus that causes uncertainty about previous attitudes or experience. In these situations, consumers are more likely to gather additional information, formulate or revise evaluative criteria, and deliberate more about alternatives, although they may still take shortcuts, simplify, or use heuristics. Few consumers collect all available information, carefully consider all possible choices, or use compensatory decision rules that weight all product characteristics. The economic model of rational choice suggests that they may not want to collect all available information because the collection and decision process is costly. Learning about all product characteristics, identifying sellers, collecting information about prices and characteristics of specific product choices, and evaluating alternatives are time-consuming and may include explicit expenses. This is consistent with the hypotheses of economists that consumers will collect additional information only as long as the cost of the search is less than its benefits.

In contrast, consumers tend to limit extensive deliberative behavior in situations where they perceive a special opportunity that would not be available in the future, have an urgent need, or are satisfied with a previous purchase of the item. Such decisions still may include important elements of rational decision making, however. Even consumers who perceive an urgent need, such as a need to replace an important household durable good or an automobile, may recognize the problem in advance and take steps to prepare for the eventual purchase.

Survey work has also provided evidence that regular payments have had an additional role in budgeting, called "precommitment" or "mental accounting" in some studies. The practice of precommitment can involve costs, but evidence suggests that many consumers are willing to pay to protect themselves against their own bad habits. While, strictly speaking, such behavior does not represent definitional economic rationality, it does not imply irrationality, either, if that term means uncontrolled credit use outside the general boundaries posed by the economic theory devised by Fisher, Hirschleifer, Juster and Shay, and others.

More recent work by Kahneman and Tversky and others on decision making under risk and uncertainty has further enhanced the interest of economists in psychological influences on economic choices, including credit use. Much of this work involves an experimental approach rather than surveys and does not involve specifics of credit use per se, although it has been influential in developing hypotheses in this area. Resulting theorizing about such things as various cognitive biases that result from individuals' use of heuristics (simplified decision rules), a tendency for individuals to prefer avoiding losses more strongly than acquiring gains, and experimental and other evidence suggest that individuals discount proximate outcomes more than distant ones. If discount rates vary by time horizon, then the choice between two options might differ depending on when the choice is made. Such behavior might lead individuals to deviate from optimal intertemporal allocations depending on the time period in question. This possibility immediately raises questions about such things as shortsightedness and self-control. New behavioral theories of this kind can challenge assumptions about rationality in economic decision making, including decisions about consumer credit use.

But evidence suggests that experimental studies of cognitive biases are sensitive to the format, context, and content of the problems presented to participants. They suggest that considerable care is required to design meaningful experimental questions and to produce appropriate conclusions. Some of the problems presented to participants in experimental studies likely do not reflect the problems actually experienced by most individuals in making decisions under uncertainty, and participants in experimental studies may not use the same decision processes that they use in making actual decisions. Experimental problems often appear more similar to test questions than choices that consumers actually face in the markets. Hypothetical situations are likely perceived as such by study participants. And it seems unlikely that participants in experimental studies view the consequences of their choices as very important. In an experimental study, as opposed to in the "real world," there is little cost to making an error and not much reward for efforts to provide a correct response. Consequently, results of the experimental studies should be interpreted with considerable caution and cannot be applied to specific problems without an understanding of the decision process and the environment.

Although it seems reasonable to conclude that individuals sometimes do make cognitive mistakes, we cannot directly conclude that all, most, or even many human decisions are influenced by cognitive biases, however. Further, individuals may be predisposed to impulsive behavior, but they also have the capacity to exert self-control to implement forward-looking plans. Self-control requires actively maintaining attention to the plan. An individual facing an impulse might yield to the impulse if it does not perturb the plan too much. To be effective, self-control requires that the internal inhibitions become stronger as awareness of the cost of impulsive behavior increases. It is not clear that participants exert the same cognitive efforts in experimental situations that they exert in actual situations where commitments in money and duration are great, past experience and information are insufficient or obsolete, and outcomes of previous decisions are regarded as unsatisfactory. Assessing actual decisions requires understanding the cognitive process and the environment in which the decisions are made, as marketers have pointed out for decades with buyer behavior models and derivatives of them.

Thus, it is worth remembering the definition of rationality as behavior aimed to achieve one's goals or objectives. In many situations simple heuristics can often perform as well as rules based on more detailed definitions of rational decision making. Studies in a variety of areas present evidence suggesting that heuristics provide accurate predictions in many areas but require less information to implement, although, to date, the applications of theories have generally been to relatively simple problems theories on use of specific heuristics in consumer credit decisions or cognitive biases arising from such use have not specifically been tested.

Concerning time discounting, the evidence from a variety of studies suggests that individuals tend to discount proximate prospects more highly than more distant ones; but for long-run time horizons (that is, greater than a year), discount rates appear to be approximately constant, the latter consistent with the standard expected utility model and economists' notion of rationality. The tendency to discount proximate amounts more highly can cause harm. Sometimes the harm is great, as in the case of addiction, for example, but individuals make numerous intertemporal decisions, and in most cases, they do not suffer any apparent harm. Individuals have cognitive control structures that enable most of them to resist temptation for impulsive immediate gratification and undertake actions to achieve goals. Individuals can also choose various external precommitment mechanisms to control impulsive behavior. External controls may not always produce optimal outcomes, but they represent purposeful actions to achieve desired goals. Thus, concluding that hyperbolic discounting is in itself always irrational or that individuals generally do not make purposive and deliberate intertemporal choices is not justified at this time.

Regarding consumer credit, evidence is limited, but empirical evidence on credit card behavior, suggests that consumers generally behave as economic theory predicts and that when consumers make mistakes, the mistakes are small or are usually corrected when large. Consequently, it is not at all clear that behavioral research undermines neoclassical economic theory of credit use as much as it enriches and enhances it. Instead, the behavioral analyses suggest the details of the elements of rational economic choice and where the theory should accommodate differences. More on this point will become known in the future as economists model consumer credit behavior more fully, employing more fully the insights from behavioral sciences and testing the enlarging body of theory with specific empirical data.

Specifically concerning "Behavioral Law and Economics" (BLE), although proponents have pointed to such discussion as a basis for government regulation of credit cards, they focuses on theoretical discussion and a priori assertions but provide no empirical underpinning for the arguments. Rather, they hypothesize welfare-reducing behavior by consumers and use several ad hoc explanations based on behavioral economics to conclude that these welfare-reducing practices persist because credit card issuers prey on consumer biases. This lack of empirical evidence is especially troubling in light of the extensive existing empirical literature not discussed in BLE.

In sum, behavioral research indicates that consumers do not always make the cognitive efforts required for an extensive decision process. Individuals often take shortcuts, simplify, and use heuristics. Cognitive effort tends to be reserved for situations where commitments in money and duration are great, past experience and information are insufficient or obsolete, and outcomes of previous decisions are regarded as unsatisfactory. In situations where consumers have previous experience and are satisfied with past decisions, consumers often make choices with little further deliberation. That cognitive biases and time-inconsistent discounting exist is well established in the behavioral literature. Some research suggests that these psychological considerations could influence consumers' credit behavior. The extent to which cognitive biases and time-inconsistent discounting affect actual credit decisions is not known at this time.

But, evidence from analyses of actual credit card behavior indicates that consumers are sensitive to price, consistent with the predictions of economic theory. When a credit card company increases the interest rates on an account, consumers reduce new charges, reduce existing balances, and shift charges to other credit card accounts, and over the course of a year, they reduce total credit card balances from the level before the price increase. Based on subsequent account use, consumers generally make cost-minimizing choices, trading off interest rates and annual fees when choosing new credit card accounts. When they make mistakes, the mistakes are usually relatively small. If mistakes are large, consumers generally correct the mistakes. Although some consumers do not correct large mistakes, persistent large mistakes are not the rule. Analyses of credit card behavior based on survey data also suggest that consumers are sensitive to costs and do not incur costly mistakes. And by far most consumers believe that credit cards provide a useful service and are satisfied with their dealings with credit card companies. Thus, neither behavioral nor conventional evidence provides much support for the conclusion that market failure is pervasive.

Tomorrow: Consumer Use of Alternative Lending Products