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Naïve Consumers and Financial Mistakes

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  • Exler, Florian
  • Hansak, Alexander

Abstract

Financial contracts are complicated and consumers often do not grasp them in their entirety. This may lead to financial mistakes. We develop a quantitative theory of unsecured credit and equilibrium default in a market with sophisticated and näive borrowers who sometimes misunderstand their contracts and make financial mistakes. Näives are more prone to mistakes without internalizing this fact. When signing debt contracts, we allow agents to trade off interest rates for penalty fees. These fees make financial mistakes costly. Näives choose inefficiently high penalty fees and cross-subsidize interest rates for sophisticates. We use this framework to analyze two unexplored features of the CARD act: clearer language requirements and a limit on penalty fees in financial contracts. Clearer contract terms lead to fewer financial mistakes by everyone, while limiting fees constrains mostly näive borrowers. Both policies reduce financial mistakes and increase the welfare of näive borrowers. The effects on sophisticates differ: clearer language and fewer mistakes benefit sophisticates too. However, limiting fees reduces the cross-subsidization sophisticates receive in equilibrium and consequently makes them worse off.

Suggested Citation

  • Exler, Florian & Hansak, Alexander, 2021. "Naïve Consumers and Financial Mistakes," VfS Annual Conference 2021 (Virtual Conference): Climate Economics 242359, Verein für Socialpolitik / German Economic Association.
  • Handle: RePEc:zbw:vfsc21:242359
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    References listed on IDEAS

    as
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    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Consumer Credit; Näiveté; Financial Mistakes; Bankruptcy; CARDAct; Cross-Subsidization;
    All these keywords.

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G41 - Financial Economics - - Behavioral Finance - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making in Financial Markets
    • G51 - Financial Economics - - Household Finance - - - Household Savings, Borrowing, Debt, and Wealth
    • K12 - Law and Economics - - Basic Areas of Law - - - Contract Law

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