Russell Paper on Separating and Pooling in Response to Consumer Financial Mistakes

Jacob Hale Russell of Stanford has written Misbehavioral Law and Economics: Separating and Pooling in Responses to Consumer Financial Mistakes. Here is the abstract:

Consumers’ choices in financial contracts do not always tell us what they really want. Put differently, revealed preferences are sometimes unreliable indicators of actual preferences. For instance, consider two consumers who take out the same high-interest payday loan. One may have accurately assessed that they have an investment, such as funding a car repair or bus ticket that will transport them to work, whose expected return exceeds the cost of the loan; the other may have made a costly miscalculation about their ability to repay, a mistake that will send them into a spiral of increasing fees and debt. The two consumers may be observationally equivalent, and policy responses will have opposing effects on each group.

This paper develops a new taxonomy of responses to potential mistakes. In designing regulations, policymakers face choices along two underappreciated dimensions: (1) between separating approaches that attempt to separate consumers’ choices accurately along their preferences, and pooling approaches that allow or require consumers to be pooled into a single choice even when preferences differ, and (2) between distributing decision-making at the individual consumer level and concentrating decisions through intermediaries or rules. The decision to separate or to pool is a first-order functional choice that logically precedes other formal aspects of policymaking (standards vs. rules, taxes vs. regulations, etc.).

This paper analyzes the inevitable tradeoffs in choosing among the four categories of regulatory responses revealed by this taxonomy. For example, all things equal, separating strategies may be preferable because they give people what they really want. In practice, however, the process of matching will be difficult and/or costly. The tradeoff between distributed and concentrated solutions may have largely to do with whether we think information asymmetries, which often exist in both directions in markets for financial products, are worse for the consumer or for the institutions offering financial products. Systematizing the tradeoffs through this taxonomy is more analytically neutral than the conventional arguments raised by interventionists and non-interventionists, who rely on often unresolvable claims about institutional competence and the level of externalities in a particular market.

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