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Consumer rationality and credit card pricing: An explanation based on the option value of credit lines

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  • Sangkyun Park

    (Office of Management and Budget, USA)

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    Abstract

    An option is embedded in credit cards. Since credit cards offer open credit lines, cardholders can borrow at the same terms when they become riskier. This option value raises the zero-profit card rate. Furthermore, adverse selection occurs if cardholders are better informed about the probability of becoming riskier in the future and borrow more when they become riskier. The adverse selection can limit rate competition and keep the card rate above the zero-profit card rate. An up-front fee is not a good alternative because it is also vulnerable to adverse selection. A low introductory card rate is an effective way to avoid the adverse selection problem when asymmetric information is mainly about the change in the borrower's risk profile in the future, as opposed to the riskiness in the present period. Copyright © 2004 John Wiley & Sons, Ltd.

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    File URL: http://hdl.handle.net/10.1002/mde.1146
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    Bibliographic Info

    Article provided by John Wiley & Sons, Ltd. in its journal Managerial and Decision Economics.

    Volume (Year): 25 (2004)
    Issue (Month): 5 ()
    Pages: 243-254

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    Handle: RePEc:wly:mgtdec:v:25:y:2004:i:5:p:243-254

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    Web page: http://www3.interscience.wiley.com/cgi-bin/jhome/7976

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    1. Anjan V. Thakor & Gregory F. Udell, 2004. "An Economic Rationale for the Pricing Structure of Bank Loan Commitments," Finance, EconWPA 0411053, EconWPA.
    2. Victor Stango, 2000. "Competition And Pricing In The Credit Card Market," The Review of Economics and Statistics, MIT Press, vol. 82(3), pages 499-508, August.
    3. Shaffer, Sherrill, 1999. "The Competitive Impact of Disclosure Requirements in the Credit Card Industry," Journal of Regulatory Economics, Springer, Springer, vol. 15(2), pages 183-98, March.
    4. Brito, Dagobert L & Hartley, Peter R, 1995. "Consumer Rationality and Credit Cards," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 103(2), pages 400-433, April.
    5. Sangkyun Park, 1993. "The credit card industry: profitability and efficiency," Research Paper, Federal Reserve Bank of New York 9314, Federal Reserve Bank of New York.
    6. Ausubel, Lawrence M, 1991. "The Failure of Competition in the Credit Card Market," American Economic Review, American Economic Association, American Economic Association, vol. 81(1), pages 50-81, March.
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    Cited by:
    1. Scholnick, Barry & Massoud, Nadia & Saunders, Anthony & Carbo-Valverde, Santiago & Rodríguez-Fernández, Francisco, 2008. "The economics of credit cards, debit cards and ATMs: A survey and some new evidence," Journal of Banking & Finance, Elsevier, Elsevier, vol. 32(8), pages 1468-1483, August.

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