Consumer Rationality and Credit Card Pricing: An Explanation Based on the Option Value of Credit Lines
Managerial and Decision Economics Volume 25 Number 5 (July-August 2004)
Posted: 28 Jul 2000 Last revised: 31 Jan 2019
Date Written: May 1, 2000
An option is embedded in credit cards. Cardholders with fixed-term credit lines borrow more when they become riskier. This option value raises the zero-profit card rate. Furthermore, the card rate can stay even higher than the zero-profit rate when cardholders are better informed about the probability of becoming riskier in the future. The expected gain from obtaining a credit card is more sensitive to the card rate for borrowers who are more likely to become riskier in the future. Those borrowers expect to use more credit card loans and save more on interest costs. Thus, unilaterally lowering the card rate causes adverse selection, which limits rate competition.
Pricing the option value with an up-front fee is not a good alternative because the up-front fee is also vulnerable to adverse selection. Borrowers with a higher probability of becoming riskier in the future are more likely to obtain a card charging an up-front fee instead of a high card rate. If a borrower becomes riskier, he/she saves more from a fee card that offers a lower rate. Thus, the attractiveness of fee cards increases with the probability of becoming riskier.
A low introductory card rate (teaser rate) is an effective way to avoid the adverse selection problem when asymmetric information is mainly about the future-period, as opposed to the present-period, riskiness of borrowers. Since the low introductory rate does not apply in the future, it does not favor borrowers who are more likely to become riskier in the future. The model focusing on the option value of credit lines, therefore, is capable of explaining high card rates and high cardissuers' profits without relying on consumer irrationality and consistent with the prevalence of teaser rates and the reduced profits of cardissuers in recent years.
JEL Classification: G10, D80, D40
Suggested Citation: Suggested Citation