Credit Cards - A Failed Market

The bankruptcy bill was passed by selling the idea that credit users were running up unnecessary debts and then discharging them in bankruptcy instead of paying them off, essentially passing the costs off to honest credit card users who paid their bills. It implicitly assumed that credit card companies were controlling risk when they issued credit and that revenues were commensurate with costs plus a fair but not unreasonable profit. This is what the basic theory of a free market would predict. But Elizabeth Warren at Talking Points Memo – Bankruptcy shows this is not what is happening.

First Ms Warren lays out the history of credit card charges and profits since 1980. Then she presents the following description of current market pricing:

”A number of younger economists have explored credit card pricing, developing a much more nuanced theory of how it exploits lack of consumer information and systematic cognitive errors. Oren Bar-Gill penned a detailed analysis of how credit card companies use dozens of tricks in their contracts to encourage customers to underestimate costs and overestimate their repayment schedules. He shows that even in a competitive market, these pracrices can lead to welfare losses. Lawrence Ausubel has demonstrated that, while people will shop for introductory interest rates, they are far less likely to re-shop when new fees and penalty rates are imposed on them. A recent article in the Quarterly Journal of Economics by Stefan Della Vigna and Ulrike Malmendier examines pricing strategies in various consumer markets and concludes, “for all types of goods firms introduce switching costs and charge back-loaded fees. The contractual design targets consumer misperception of future consumption and underestimation of the renewal probability. The predictions of the theory match the empirical contract design in the credit card, gambling, health club, life insurance, mail order, mobile phone, and vacation time-sharing industries.” [Underlining is mine - RB]

"The lesson is clear: credit card companies can maximize profits by pricing introductory rates competitively and then hitting customers hard later on with fees and penalties. And that model certainly seems to fit the data on revenues. Today, credit card fees and late charges amount to $50 billion—about half of all credit card revenues."

In other words, credit card contracts are specifically designed to mislead credit card users and extract excessive profit from them. Since the costs of providing credit cards does not increase significantly in each risk category when more credit cards are issued, all of the additional fee revenue goes directly to profit. The history of the credit card companies shows that when costs are reduced they do not pass the lower costs to the customers. They compete through advertising lower interest rates, not by actually providing lower cost credit cards. When fee revenues are increased, they simply make more profit.

So the bankruptcy bill means that the government has become a collection agent for credit card companies who no longer need to consider controlling risk when issuing credit cards, and the increased revenue will go directly to their profits.