At PopMatters, I have been writing a bit about financial innovation and the vanilla-option reform that was recently dropped from the Consumer Finance Protection Agency legislation. The provision would have forced banks to offer basic, straightforward, “plain vanilla” financial products so that consumers would have a baseline from which to gauge what sort of risks they are taking on with more “innovative” offerings. Steve Randy Waldman explains here the importance of this sort of reform: “Consumers know they are at a disadvantage when transacting with banks, and do not believe that reputational constraints or internal controls offer sufficient guarantee of fair-dealing.”
Hence the plain-vanilla option. The banks lobbied against it — no surprise, since it is a healthy profit center for them and moreover, supplies the ideological underpinnings for their way of doing business: make money by making necessary social products too complex for most people in society to understand, and then reap benefits from the confusion.
In this post, Mike Konczal brought up a 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.” The Gabaix and Laibson 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. Konczal notes that “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.” Take this one step further and one can see how firms would have incentive to manufacture naivete, an aim that could supplant whatever it is they are nominally in business to do. Then Hayek’s argument in “The Use of Knowledge in Society” is turned on its head — these markets aggregate ignorance, as one of Felix Salmon’s commenters explained.
The cross-subsidies work their dark magic not only with hidden fees but with a more-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 ignorant 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 regarded as standard for middle-class people.
To take Konczal’s example, 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!
The upshot: Banks get to play divide and conquer to keep their profits up. And worse, they compete on how well they divide and conquer, not how well they serve customers. This is one of the reasons no amount of consumer dissatisfaction seems to affect the ways banks, cell-phone providers, health insurance companies, etc., treat customers. They thrive on the chaos and know we have no viable exit option.
The across-the-board shoddy service — “complexity” — might be regarded as evidence of tacit collusion among suppliers. But in this post, Karl Smith argues that such complexity is not evidence of collusion but constraint, echoing the conclusion of Gabaix and Laibson.
It’s not that firms refuse to compete by providing consumers the best products — it’s that they cannot compete in this way because consumers will naturally gravitate towards products which are bad for them.
That makes it sounds like customer ignorance is a flat given of the situation and we insist on choosing badly. But he goes on:
That is, if you are offering a product that is just the same as the standard vanilla product but has some hidden tail risk then you can necessarily offer it a lower price. This implies that you will dominate the market until the tail event occurs. Thus consumers will be consistently taking on more risk than they realize.
It’s not that we’re stupid; it’s that we are duped by the “hidden tail risk” (i.e. the broader ramifications of the decision in question) concealed by the products’ complexity. If a vanilla product existed, we could recognize the tail risk in the price discrepancy and consider more carefully whether to take it on. (That’s Waldman’s point.)
So whether you think banks are conspiratorially and malevolently colluding to screw us over, or that they are forced by bad equilibria to do it, the outcome is the same: competitors push each other down the road of “innovating” greater complexity and yielding more widespread ignorance.
Here we see in stark form the consequences of imperfect markets and the flaws in the free-marketeer assumption that competition among firms automatically yields optimal outcomes for consumers. After all, firms compete for profit, not to help or satisfy people. 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 call it innovation, moving the goal posts as consumers struggle to educate themselves. That in turn gives us consumers incentive to hop off the learning treadmill and either hire an expert, opt out and subsist as a second-class citizen, or resign ourselves to be taken advantage of by a variety of fat cats.