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Exploiting Naivete about Self-Control in the Credit Market

Author

Listed:
  • Paul Heidhues
  • Botond Koszegi

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)

Suggested Citation

  • Paul Heidhues & Botond Koszegi, 2010. "Exploiting Naivete about Self-Control in the Credit Market," American Economic Review, American Economic Association, vol. 100(5), pages 2279-2303, December.
  • Handle: RePEc:aea:aecrev:v:100:y:2010:i:5:p:2279-2303
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    File URL: http://www.aeaweb.org/articles.php?doi=10.1257/aer.100.5.2279
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    References listed on IDEAS

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    More about this item

    JEL classification:

    • D14 - Microeconomics - - Household Behavior - - - Household Saving; Personal Finance
    • D18 - Microeconomics - - Household Behavior - - - Consumer Protection
    • D49 - Microeconomics - - Market Structure, Pricing, and Design - - - Other
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law

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