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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)

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.

Suggested Citation

  • Sangkyun Park, 2004. "Consumer rationality and credit card pricing: An explanation based on the option value of credit lines," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 25(5), pages 243-254.
  • Handle: RePEc:wly:mgtdec:v:25:y:2004:i:5:p:243-254
    DOI: 10.1002/mde.1146
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    References listed on IDEAS

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    1. Thakor, Anjan V. & Udell, Gregory F., 1987. "An economic rationale for the pricing structure of bank loan commitments," Journal of Banking & Finance, Elsevier, vol. 11(2), pages 271-289, June.
    2. Sangkyun Park, 1993. "The credit card industry: profitability and efficiency," Research Paper 9314, Federal Reserve Bank of New York.
    3. Brito, Dagobert L & Hartley, Peter R, 1995. "Consumer Rationality and Credit Cards," Journal of Political Economy, University of Chicago Press, vol. 103(2), pages 400-433, April.
    4. 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.
    5. Ausubel, Lawrence M, 1991. "The Failure of Competition in the Credit Card Market," American Economic Review, American Economic Association, vol. 81(1), pages 50-81, March.
    6. Shaffer, Sherrill, 1999. "The Competitive Impact of Disclosure Requirements in the Credit Card Industry," Journal of Regulatory Economics, Springer, vol. 15(2), pages 183-198, March.
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    Cited by:

    1. Akin, Guzin Gulsun & Aysan, Ahmet Faruk & Kara, Gazi Ishak & Yildiran, Levent, 2008. "Non-price competition in credit card markets through bundling and bank level benefits," MPRA Paper 17768, University Library of Munich, Germany.
    2. G. Gulsun Akin & Ahmet Faruk Aysan & Denada Boriçi & Levent Yildiran, 2011. "The Role of Simultaneous Regulations of Credit Services and Payment Services on Competition," Working Papers 604, Economic Research Forum, revised 08 Jan 2011.
    3. 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, vol. 32(8), pages 1468-1483, August.

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