Market-made ignorance (2 Oct 2009)

More about financial innovation and the vanilla-option reform. Why? Because this particular problem illustrates well the consequences of imperfect markets, highlighting flaws in the assumption that competition produces optimal outcomes for consumers. Firms compete for profit, not to help or satisfy customers. And in some of the most critical markets we as consumers must enter, the firms we deal with have reason to try to confuse us and make poor choices, and no competing firms have any reason to undercut them and force them into more ethical behavior. In short, the suppliers in markets for health insurance and mortgages and so on have reason to keep their products complex and their customers ignorant, and will continue to produce more complexity and move the goal posts as consumers struggle to educate themselves. That in turn gives us incentive to hop off the learning treadmill, and either hire an expert, opt out and live as a second-class citizen, or resolve to be taken advantage of by fat cats.

In this post (which you should read first), Mike Konczal brought up this paper (pdf) by economists Xavier Gabaix and David Laibson about "shrouded product attributes" -- econospeak for hidden fees and the like. The paper, as Konczal explains it, is "a look at markets where there are low cost, high hidden fee firms, and how competition from medium cost, no fee firms will lose. What’s interesting about this is it is generalizable to a wide variety of favorable market conditions (zero-cost advertising, for instance). And luring sophisticated consumers away won’t work as they are cross-subsidized by the naive consumers paying fees." In practice, the paper suggests that companies can't make money by disclosing all possible hidden fees in their particular line of business and charging a little more for their honesty. Those companies will get driven out of business by the companies that charge a raft of fees and reward savvy consumers with bargains.

That remains true not only with hidden fees but with generalized confusion about the pricing of products and options offered. Firms may find themselves with incentives to present their product and pricing schemes confusingly (think cell-phone service providers) because the ignorant won't know they are being bilked and the hypervigilant will be "cross-subsidized" -- they will be able to save at the suckers' expense and won't want to deal with a more straightforward firm. That leaves ordinary people -- neither stupid nor obsessive -- with the unpleasant choice of having to do battle with such firms (in the "market for lemons" rife with information asymmetries) to procure goods/services that are now part of standard social life in the U.S.

Konczal's point is that this logic applies to financial products -- we need loans and credit cards to get along in the modern world, but banks have no incentive to offer a more straightforward version of these products. Instead they have reason to pit their customers against each other:

I saw this cross-subsidized problem first hand talking about the credit card bill earlier in the year. People were upset their “free” points were going to take a hit as a result of banning high interest rate jumps off those who miss a payment and letting credit card markets reset along those lines. If they were “free” because they were subsidized in part by mislead consumers is that a just and/or fair arrangement? I suppose it depends on what you think about mislead consumers – if they are struggling as a result of increased income volatility or health care cost shocks, piling on them strikes me as unjust. But explain that to someone who is flying for free off them!

Banks get to play divide and conquer to keep their profits up.

Karl Smith has a post that puts the issues in a slightly different context. His conclusion: "The key here is that the innovation creates economic rents but its not produced by collusion or even market power. Its better thought of as a tax on consumers that is collected by those able to produce the most opaque products."