Supreme Court Economic Review is an interdisciplinary journal that seeks to provide a forum for scholarship in law and economics, public choice, and constitutional political economy. Its approach is broad ranging and contributions employ explicit or implicit economic reasoning for the analysis of legal issues, with special attention to Supreme Court decisions, judicial process, and institutional design.
About the Author
Michael S. Greve is a professor at George Mason University School of Law and teaches constitutional law. Thomas W. Hazlett is Professor of Law and Economics and serves as Director of the Information Economy Project at George Mason University School of Law. He is also a Columnist for the New Technology Policy Forum hosted by the Financial Times. Todd J. Zywicki is George Mason University Foundation Professor of Law at George Mason University School of Law and Senior Scholar of the Mercatus Center at George Mason University. He teaches in the area of Bankruptcy, Contracts, Commercial Law, Business Associations, Law and Economics, and Public Choice and the Law.
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Supreme Court Economic Review Volume 22
By Ilya Somin, Thomas W. Hazlett, Todd J. Zywicki
The University of Chicago PressCopyright © 2015 The University of Chicago
All rights reserved.
An Assessment of Behavioral Law and Economics Contentions and What We Know Empirically about Credit Card Use by Consumers
Thomas A. Durkin, Gregory Elliehausen, and Todd J. Zywicki
"Behavioral Law and Economics" (BLE) is a specialized component of the legal literature that purports to base its conclusions on a branch of economic analysis known as behavioral economics. The central claim of BLE is that by applying findings of behavioral economics to the real world it can provide more accurate assumptions about individual behavior and decision making than neoclassical economics and thus better and more effective policy prescriptions where needed. To date, however, BLE's claims have been almost entirely a priori, taking certain suggested biases identified in the laboratory experiments by behavioral economists and claiming that they extend significantly to actual consumer behavior and the need for regulation. Yet it is well accepted that the proper test of the scientific validity of an economic theory is the accuracy of its predictions relative to empirically testable hypotheses, not a priori reasoning or hypothetical extensions. This paper focuses on an area where BLE has been particularly active and even influential — the analysis of consumer use of credit cards. Comparison of the claims of BLE against hypotheses of the traditional neoclassical model of consumer credit use developed over the past century finds that available empirical evidence uniformly rejects BLE's hypotheses for consumer credit. In short, while behavioral considerations are an important component of economic analysis, its BLE extension to policy in the consumer credit area has not yet proven to be useful.
Careful study of the economics of consumer credit use and its underlying consumer decision making dates back almost a century, to the period before the Great Depression. In subsequent decades, economists have refined this theoretical model and provided numerous empirical confirmations of the conclusion that consumer credit use can be explained by rational decisions among users.
In recent years, however, this long-standing and well-confirmed model has been challenged by individuals offering a contrary model. "Behavioral Law and Economics" (BLE) purports to ground policy, especially consumer protection policy, in a "more realistic" model of human behavior than traditional economic analysis resting on rationality. It implicitly boasts that its approach will provide more accurate predictions of individual decision making than the traditional model and, therefore, better policy prescriptions. To date, however, this claim rests primarily on extrapolations from laboratory experiments involving hypothetical choices and has been subject to minimal empirical testing in real world contexts.
Despite the absence of empirical testing, advocates of BLE have often claimed to identify in the credit area substantial market failures that reduce consumer welfare. Further, they have proposed aggressive policy prescriptions based on their theories. Indeed, the establishment of the Consumer Financial Protection Bureau as part of the Dodd-Frank financial reform legislation in 2010 was closely tied to the policy agenda of BLE proponents. In contrast to the traditional economic model of consumer credit, BLE proponents not only conclude that consumers suffer from certain welfare-reducing biases in their use of credit, but also suggest that consumer lenders implicitly prey on those biases through their product design and marketing.
In this Article, we identify predictions about consumer credit use found in BLE literature and review the available empirical evidence to determine whether BLE indeed meets its claim of providing a more accurate predictive model of individual choice concerning consumer credit use. The particular focus here is on credit cards because they have played a prominent role in the BLE literature as supposedly illustrating the value of adopting a different view of consumer credit. This Article joins some new discussions elsewhere on other areas of consumers' credit use (mortgage loans, payday loans, and bank overdraft protection).
Among the BLE prescriptive papers focusing on consumers' financial behavior, one of the best known is a lengthy theoretical and policy discussion about credit cards by law professor Oren Bar-Gill titled "Seduction by Plastic." We also discuss where relevant other papers within this genre, but Bar-Gill's paper is useful as a foundation for further review because it has been widely quoted and it directly suggests testable hypotheses.
The rest of the Article proceeds as follows. In Part II we briefly examine traditional economic and financial microeconomic theory of credit use developed in the twentieth century and then look at new BLE theories of the same phenomena. For the latter, as indicated, we focus especially on possibly its best known exposition, the widely quoted paper by Professor Oren Bar-Gill. In the process of describing BLE theory of credit cards as articulated there, we seek to identify core ideas in this area and preliminarily specify readily apparent testable contentions. As part of this discussion, we compare the Bar-Gill-BLE model and its implications with the contentions of traditional microeconomics. In Part III, we examine available relevant empirical evidence.
To preview, although Bar-Gill and others have pointed to his discussion as a basis for government regulation of credit cards, in fact Bar-Gill actually focuses on theoretical discussion and a priori assertions but provides no empirical underpinning for his arguments. Rather, he hypothesizes what he believes to be welfare-reducing behavior by consumers and uses 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 the light of extensive existing theoretical and empirical literature that neither he nor other BLE scholars have addressed, much less refuted. Although Bar-Gill himself provides no empirical testing of his arguments, other economics researchers have tested BLE propositions.
II. THEORIES OF CONSUMER CREDIT USE
BLE offers a model of consumer credit use that challenges the traditional model of consumer credit use, which is rooted in neoclassical economics. First introduced by Edwin R.A. Seligman in 1927, based upon Irving Fisher's earlier model of investment and interest, and refined by Jack Hershleifer in the 1950s and F. Thomas Juster and Robert P. Shay in the 1960s, the traditional model sees consumer credit use as best explained as rational efforts by consumer to undertake wealth increasing household investments and shift consumption through time, subject to constraints. BLE, by contrast, hypothesizes that consumers are systematically irrational in their use of consumer credit. This section introduces the theoretical foundations of both models for purposes of identifying their testable hypotheses.
A. The Traditional Model of Consumer Credit: The Juster-Shay Model
Traditional economic analysis models consumers as using credit in much the same way as businesses, namely, to invest in capital goods, such as housing, automobiles, and other consumer durable goods, or to make human capital investments such as higher education and then to smooth discontinuities between income and expense flows. Such actions involve allocation of present and future income, including intertemporal shifting of spending and consuming, through using consumer credit.
The theory of consumer credit was developed by Irving Fisher, Edwin R.A. Seligman, Jack Hirshleifer, F. Thomas Juster, and Robert P. Shay in the early part and middle of the twentieth century. Fisher formulated a model that considered production, borrowing or lending, and consumption decisions over time. The model demonstrated that borrowing opportunities can enable a household to undertake more productive investment and then borrow or lend to achieve more highly valued current and future consumption than would be possible without borrowing and lending opportunities. In a perfect market (that is, a market with a single, constant borrowing and lending rate of interest, a theoretical constraint relaxed in later work by others), the investment decision is to choose the amount of investment that maximizes wealth, regardless of consumption preferences. Having maximized wealth, an individual may borrow or lend at the constant interest rate to obtain the preferred pattern of consumption over time.
Seligman applied Fisher's model to consumer credit decisions. He pointed out that many goods purchased by consumers are not consumed at once but instead produce a flow of services over time. He proposed that the flow of services from a consumer durable asset is not fundamentally different from a flow of income from a business investment. In each case, the objective is to procure a surplus of benefits in terms of utilities or income over cost. In the case of consumer durable assets, the role of consumer credit is to put "goods of potential productive utilization at the disposal of the consumer at an earlier period than would be otherwise practicable." In other words, consumer credit enables consumers to acquire more productive household investment in durable assets earlier without large sacrifices in current consumption to purchase the durable assets. For example, a household could purchase a washing machine on credit, thereby acquiring it earlier than if it had to save for it, while also avoiding the cost and inconvenience of alternatives, such as using a Laundromat. Thus, the washing machine can be best understood as a type of capital good for the household that provides a stream of benefits to the household. Such purchases may be especially useful to younger households just starting out. They may receive the highest value from the purchase of such goods but also are most likely to be constrained in terms of access to such credit.
Hirshleifer extended Fisher's model to markets in which the interest rate for borrowing is greater than the interest rate for lending. The extension demonstrated that the investment decision involves consideration of not only the borrowing rate but also the lending rate and rate of time preference (that is, the rate of substitution between current and future consumption). When investment opportunities provide relatively high returns, an individual might borrow to finance additional investments. An individual with relatively low-return investments might make few investments and also lend part of current income. Between these two possibilities is a third in which an individual neither borrows nor lends and the rate of time preference determines the amount of investment. This extension addressed an important limitation of Fisher's perfect capital market model.
Juster and Shay modified Hirshleifer's extension for certain institutional characteristics of consumer credit markets. These characteristics included absolute limits on the amount that individual households can borrow and the availability of unsecured credit at a higher interest rate from supplementary lenders. The existence of absolute limits to borrowing is a consequence of uncertainty and borrowers' finite ability to repay. As the amount of principal and interest rise, the likelihood of default becomes greater. Low-rate credit is limited by the amounts of equity and collateral that the borrower is able to provide. Unsecured supplemental credit may be available at higher rates, but such credit is available only in amounts well below levels that make default probable. When returns to household investment are relatively high, Juster and Shay's model showed that use of higher rate supplemental credit may be utility increasing. Another notable contribution of Juster and Shay is the suggestion that in many cases the evaluation of household investments may not be especially onerous. For example, the cost of replacing an item may be compared with the cost of its repair and maintenance, consumers can compare the cost of purchasing an item with the cost of leasing it, or goods may have close substitutes in services provided in the market. Thus, the relative dollar values of benefits are often readily available to consumers.
When Juster and Shay published their study, supplementary credit was primarily in the form of personal loans from banks and finance companies. These forms of credit still exist, but credit cards have since become an additional source of supplemental credit. Credit cards eliminate the need to incur transaction costs for seeking out and applying for a loan each time credit is needed. Brito and Hartley showed that even very small transaction costs can make credit card borrowing an attractive alternative to personal loans. This conclusion is especially relevant for small loans from other sources, which may carry interest rates of 36 percent or more.
B. Behavioral Law and Economics
In contrast to consumer credit (including credit card credit) use for rational economic reasons, BLE instead has offered "Seduction by Plastic" (the title of Bar-Gill's article in the Northwestern University Law Review). In that article Bar-Gill contends that consumer behavior with respect to credit cards exhibits two chronic behavioral biases: (1) consumers show imperfect self-control concerning sticking with their future borrowing and repayment intentions, a phenomenon he calls the "underestimation bias"; and (2) they also underestimate the likelihood of adverse events that might cause them to need to borrow, which he calls the "optimism bias." In his view, these two biases are behind what he considers to be excessive borrowing on credit cards. Moreover, he seems to assume implicitly that these biases are systematic and irremediable through learning.
As supporting evidence for the underestimation bias, he offers a small collection of examples not involving credit use: Homer's ancient story of Ulysses and the Sirens; a dieter on a treadmill who later falters at a restaurant "when the dessert cart is steered past the table and his mouth starts to water and he caves in and orders the chocolate cake"; makers of New Year's resolutions, "quickly forgotten when February replaces January"; and setters of alarm clocks, "only to be turned off and ignored the next morning." From these simple examples, he leaps directly to assertions about significant financial behavior: "And weakness of the will also explains consumers' underestimation of their future borrowing. Often the consumer will end up borrowing on her credit card, despite her ex ante assertions not to borrow." He does not elaborate on how often is "often."
He then argues for the second bias that he alleges causes substantially more borrowing than planned: "The second bias underlying the underestimation of future borrowing is the optimism bias." As supporting evidence he again offers a few speculations, this time about how consumers underestimate the likelihood of adverse events like accidents or costly illnesses, without further analysis about frequency, financial impact, asymmetries, or other aspects of such estimates.
The evidence he offers in both areas is weak, and, without worrying here yet about evidence, it is equally possible to argue another set of contentions about credit cards: namely, that even if these characteristics describe some consumers sometimes, the number is quantitatively small to the point that their impact on the overall functioning of credit markets is unimportant. If so, then standard economic analysis is not undermined as a descriptor of the fundamentals of consumer behavior with respect to credit, even after taking into account the findings and contentions of the psychologists and the survey researchers and marketers concerning variations in consumer behavior. Credit cards, then, represent the coming of technological change in the form of plastic credit access devices, more effective screening of applicants for unsecured credit, and the new availability of extensive, low-cost communications networks for managing traditional credit demand and supply. Which hypothesis is correct? Merely stating contentions does not prove either point.
Excerpted from Supreme Court Economic Review Volume 22 by Ilya Somin, Thomas W. Hazlett, Todd J. Zywicki. Copyright © 2015 The University of Chicago. Excerpted by permission of The University of Chicago Press.
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Table of Contents
An Assessment of Behavioral Law and Economics Contentions and What We know Empirically about Credit Card Use by Consumers Thomas A. Durkin Gregory Elliehausen Todd J. Zywicki 1
Inside the Blackwall Box: Explaining U.S. Marine Salvage Awards Joshua C. Teitelbaum 55
Less Protection, More Innovation? Murat C. Mungan 123
Doctrinal Antithesis in Anglo-American Administrative Law Eric C. Ip 147
How Merger Regulation Became Unreasonable and How to Fix It Sheldon Kimmel 181
The Myth of the Condorcet Winner Paul H. Edelman 207