In a few high-profile markets, prices seem to stay far above average cost even though there are tons of competitors. There are thousands of credit card issuers, but the average interest rate is 18.26%. There are over 100,000 real estate brokerage firms, but the default commission remains 6%. Sure, unsecured credit has a high default risk, but high enough to justify an 18.26% rate? And why on Earth would it cost $60,000 to sell a million-dollar home?
From the standpoint of economic theory, such industries are deeply puzzling. In monopoly models, prices stay above average cost forever, but calling an industry with thousands of competitors a “monopoly” seems absurd. In oligopoly and monopolistic competition models, prices stay above marginal cost forever, but entry should still drive prices down to average costs.
My UT friends John Hatfield and Richard Lowery (plus Scott Kominers) have a model where realtors are basically a giant cartel that crushes price competition with the threat of ferocious retaliation. (More elaboration here and here). The HKL math is impressive, but ultimately it’s an incredible conspiracy theory. What evidence is there that realtors really are unleashing hell on price-cutters? I see cut-rate realtors in my neighborhood all the time. And the same is even clearer for credit cards. Zero-interest offers show up in my mailbox on a regular basis.
What’s really going on? I propose a much simpler model than HKL. Namely: In some industries, many consumers foolishly fail to shop around. Maybe they’re lazy. Maybe they’re fatalistic. Maybe they don’t want to look cheap. Maybe they don’t want to look weird. Whatever the non-shoppers’ motivation, however, the result is the same. If firms know that many consumers don’t shop around, then one profit-maximizing business model is simply to charge a high price and see how many suckers come along.
Sure, rival firms will compete for the price-sensitive consumers. Or maybe each firm will charge an easy-to-see high price for suckers and a (slightly) harder-to-see low price for bargain-hunters. Either way, however, we’ll see a long-run equilibrium where a lot of people pay prices that far exceed average cost. Indefinitely.
Why is my model better than HKL? Because it explains the same facts – lots of firms persistently charging above average cost – without straining credulity.
Look around with your own eyes. Don’t you see lots of people who stubbornly fail to shop around, even though shopping around totally works? I sure do. For virtually any major purchase, I ask the vendor, “Can you do any better?” And guess what? They cut my price two-thirds of the time. Everyone else pays full price.
The same goes for realtors. Discount realtors advertise publicly. And several of my friends have negotiated commission cuts with “full-price” firms. A little self-advocacy can easily yield $10k in savings. For credit cards, I know grad students who did 0% balance transfers over and over, receiving many thousands of dollars of unsecured credit for negative real interest rates despite their very low income. All fueled by the power of gumption and frugality.
As a classic Payless commercial from the 80s remarks, “You could pay more, but why?”
Should we deem this situation a “market failure“? Only if you hold markets to impossibly high standards. If consumers pay high prices because they refuse to shop around, many businesses will naturally charge high prices. But in such scenarios, it makes far more sense to say that it is not the market, but the consumers, who have failed.
READER COMMENTS
TGGP
Feb 23 2022 at 10:02am
“Price discrimination” within a firm in which the consumers willing to put in the most effort to get a lower price (say, by threatening to cancel their cable subscription) pay less makes sense (and makes monopolies more efficient!). But I don’t know if it explains some firms charging high prices while other firms charge lower ones.
John Hall
Feb 23 2022 at 10:05am
For real estate, laws and regulations historically entrenched brokers and their prices.
A significant component of the high average interest rate on credit cards likely reflects the higher risk issuers face from those who actually carry balances. Also note that even if you have a 0% interest rate after a balance transfer, there is still a fee to do them. They aren’t free.
Anonymous
Feb 28 2022 at 1:40pm
There used to be many no-fee offers. However since a law was put in place that payments have to go towards the highest-interest-rate debt, that changed. Now there are no no-fee 0% offers. Previously consumers would take a 0% transfer, charge more purchases and not pay them off right away, and pay interest on those new purchases while payments went towards the 0% debt, which allowed credit card companies to charge no fees and still profit.
In terms of 0% for purchases, typically there are no fees but the 0% is for a limited time (12-18 months).
Dave Smith
Feb 23 2022 at 10:25am
Of course it might really cost 6% to sell a house.
MarkW
Feb 23 2022 at 10:42am
Or a realtor may work harder when they’re in line for a higher commission. And there are usually two realtors involved — the one representing the seller and the one ‘supposedly’ representing the buyer (they don’t but few know this). Both may work harder and preferentially show the houses of those paying full price commissions.
There are a whole lot of principal/agent problems in real estate sales. For example, realtors often push sellers to do upgrades — why? Because the seller is likely to make more on the sale? No! It’s a alternative to getting the seller to cut the price, but it’s better for the realtor because it makes a sale at the current price more likely and doesn’t actually reduce the commission (as actual price cuts do). The same goes for the absurd practice of including allowances in the sale price for upgrades.
Dylan
Feb 23 2022 at 11:04am
Doesn’t your theory have an even harder problem to explain, namely why these same consumers fail to shop around only in some industries? Why do consumers shop around for mac and cheese or gasoline (where I know many, many people who will drive miles out of their way to save $0.08 a gallon), but they don’t do it for transactions where the potential for savings is far greater?
Jon Murphy
Feb 23 2022 at 11:16am
I think that’s a good question. And I do not think search costs are a viable answer here given the Internet has dramatically reduced search costs.
Mark Z
Feb 23 2022 at 1:05pm
I think you’re underselling search costs as a viable explanation. It’s not just about time or convenience, but also seller reputation. If I saw a brand of mac and cheese at the store that I’d never heard of that’s cheaper than the usual variety, I would be much less hesitant to buy it than I would to get a credit card from a company I’d never heard of. My out-of-the-blue hypothesis: with realtors and credit cards, customers think there’s a much higher chance of getting swindled somehow if they go with an ‘off-brand’ version of common consumer goods.
For goods with a higher transaction frequency – like food – experimentation with new brands is pretty cheap, whereas you only buy or sell maybe a few houses in your life, so reputational capital probably matters a lot more for industries based on very few, very big transactions, and makes sellers more ‘monopolistic’ among people with whom they have reputational capital. All speculation, of course.
Mark Z
Feb 23 2022 at 1:06pm
Correction: “getting swindled somehow *than* if they go with an ‘off-brand’ version of common consumer goods.” I need to start rereading my comments before submitting.
Jon Murphy
Feb 23 2022 at 3:46pm
That’s a real good point Mark Z. If I may rephrase your point: it’s a question of “the devil you know” versus “the devil you do not know”
Dylan
Feb 24 2022 at 11:17am
I think there is an easier explanation (for credit cards at least) than search costs and brand reputation, since searching for “low interest rate credit cards” brings up tons of options from well known brands. However, most of these are of the 0% balance transfer for X number of months type. I think a behavioral explanation is more obvious, when you are shopping for a credit card I’d wager the vast majority of people are not expecting to pay interest, they are expecting to be good and pay it off at the end of the month. Or, if they already have a balance, they think they will do a balance transfer and will be able to pay it off before the year expires. Most people expect to be better versions of themselves in the future than they have been in the past. It works for diets and gym memberships too.
A far bigger mystery in my mind is why the fees charged to merchants are so uniform. Perhaps this can be explained by oligopoly, with only the big 3 credit card processors. But, now you also have Paypal and Venmo and Stripe and countless others, yet the merchant fees remain pretty constant. Why?
Everett
Feb 25 2022 at 5:31pm
I expected to not pay my credit card off, and didn’t want to risk being stuck with a very high interest rate compared to the 9 – 10% rate on my then current cards. And as has been mentioned, there’s a fee to do the balance transfer, which gets tacked on to the principle I owe. And it’s not like I gain a lot if the new card’s limit is lower than what I owe on my current cards. In that case I’m stuck with additional minimum monthly fees to pay and yet more creditors to juggle.
Alan Goldhammer
Feb 23 2022 at 5:32pm
It’s not search costs per se, but rather a leveling of prices that the Internet has brought. In the absence of supply chain problems, it is difficult for a retailer to charge more than a competitor or they lose business. When we were shopping for some new appliances for the condo we bought last December, the price was the same for the four appliances that we selected (washer, dryer, microwave, slide in induction range) regardless of the retailer.
PaulS
Feb 23 2022 at 1:07pm
Actually I drive past a number of gas stations every day, so knowing which one (if any) is outrageously expensive is very easy. Food stores and the like are a little more complicated, but I tend to use more than one, since there are all sorts of arbitrary limitations on who carries what. It still tends to be somewhat easy to tell which one is outrageously expensive, and write it off.
OTOH, applying for a new credit card usually turns into a bureaucratic hassle fairly quickly (credit rating, etc.) and incurs yet another monthly hassle with passwords, logins, etc. (or else maybe a monthly snail-mailer) to manage it. It may or may not also incur service charges even if lightly used or unused.
And canceling an old *anything* that’s essentially subscription based, including a credit card, is often a gigantic hassle. There’s a reason why companies push subscriptions so very hard, extricating oneself is often nearly impossible.
And oftentimes, the low-interest credit-card offer is only temporary, and understanding the specifics may involve wading through fine print. One would have to do it all over again once or twice a year.
I think the (typically large) businesses involved in all this know full well what they’re doing – they pay executives countless millions apiece to work it out – and blaming it all on folks who don’t have endless time on their hands is not very fair.
Colin
Feb 23 2022 at 4:51pm
After my first time buying a flatscreen TV, I now direct all my friends to Video Only whenever they’re shopping. The most common reaction is “maybe I could save a couple $hundred but I’d rather order it from Amazon and not have to haggle.” Sometimes I’ll offer to haggle for them, but that’s yet to change the outcome here. I suspect my friends prefer the comfort of “Amazon is a known quantity”. AKA risk aversion.
Haggling isn’t exactly in style, and “shopping around” for my generation looks a lot like “sort by price on whatever shopping app I use”. Gas is a weird outlier. I wonder if it’s because of just how prominently the industry advertises its prices? If we all ate exclusively bananas, and every grocery store had a sign by the road advertising their banana price, would we shop around for food in the same way? If not, then the other theory is that most middle/lower-class families experience some gas shock at some point in their life which is actually disruptive: maybe these cause habits that make sense at the time around the shock and then hold on well after the shock.
J. Goard
Feb 23 2022 at 9:38pm
My first order approximation:
Because it makes sociological sense to status signal with big ticket items, and to virtue signal with frugality in one’s daily life.
Notice when many of the people who shop around for low-cost essentials don’t shop around: gifts for others, going out to eat on special occasions, a few days after receiving a windfall. This is status mode. Not caring how much your mac and cheese or gas costs doesn’t convey status amongst middle-class peers; it conveys that you’re a lazy consuming schlub who’ll take whatever they give you. Virtue mode is paying attention so you can give your neighbors hot tips on daily deals.
Dylan
Feb 24 2022 at 11:19am
Is there much value in signaling based on the amount of interest a credit card charges? Isn’t something like an Amex Platinum Charge Card that doesn’t even allow you to carry a balance more prestigious than your run of the mill Capital One credit card?
Jason
Feb 23 2022 at 10:49pm
I have a parsimonious theory with good explanatory power. (untested but I think hard to reject prima facie). The theory is that consumers are willing to punish sellers who charge more than the market rate *for purchases that are frequently repeated*. Even at cost to themselves. This is like the ultimatum game. We are willing to bear a cost to punish people who are greedy.
This explains why peoole don’t shop around for rare purchases, but do shop around for frequent purchases even though the savings are the same.
Just a private theory but ever since I dreamed it up I’ve been unable to completely reject it.
Nigel
Feb 23 2022 at 11:57am
I too am flummoxed by the persistence of high real estate commissions; although, there are fixed commission brokerages and you can always find FSBO.
I can speak to credit cards as I’ve worked in consumer lending forever.
First, you pay zero interest if you pay off every month, so while the interest rate may be 13-26%, many people pay 0% for access to short term credit and most will actually get rewards around 1-2% of purchase. What a deal!
Second, those are annualized rates. So for the group that mostly transects but sometimes revolves, they are paying much less than ~18%. A common scenario is for people to revolve a portion of their balance around Christmas (January statement) and payoff in February. If their rate is 18%, they will pay only 1.8% on the amount they revolved for the one month. If that is the only month they revolve, they are effectively paying 0% for the whole year and getting 1-2% rewards.
Those who do revolve regularly or have built up a large balance and are paying down are negatively selected. This group will charge off at over a 10% annualized rate, so you do need to charge quite a bit to make a profit. Additionally, lenders often loose money on transactors, those who payoff every month, so they have to make it up on those who actually pay interest or charge an annual fee. You keep transactors on your book to keep overall default rates reasonable so you don’t have to reserve against your portfolio as much
All in all, I don’t think credit card companies make an outsized profit. Maximum interest rates imposed by the government makes it impossible to price (interest rate) discriminate as much as lenders would like. Lenders are also limited by the FCRA and other fair lending laws in what data they can use to price discriminate. These laws make borrowing more expensive for everyone.
Daniel
Feb 23 2022 at 11:57am
The justifications for markets ARE impossibly high standards. Usually you imagine a market with intersecting supply and demand curves that come with a bunch of stated-in-the-literature-but-not-stated-in-conversation assumptions. One of those is fully-informed consumers. The complications to this type of analysis quickly add up, and dealing with them makes for great research and nuance (and microeconomics is still useful even with these assumptions!). One can formalize all sorts of biases into models, which improves them, but eventually the concept of a market failure ceases to exist:”no, the revealed demand curve is actually shifted right relative to the reservation demand curve because people are lazy, so the equilibrium price SHOULD be weirdly high” is of like kind as “no, the market supply curve of carbon-intensive energy is actually shifted right relative to the “social” supply curve because the market participants don’t actually care about carbon emissions, so the equilibrium price of carbon-intensive power SHOULD be this low.”I don’t know if we should deem this a market failure, but when every quirk of market participants is accepted away, it is impossible to believe in any limitations of markets.
MarkW
Feb 23 2022 at 1:33pm
No, it’s not. Only some consumers have to be well informed for markets to work. The best example for me is that most of my retirement savings are invested in index funds. I don’t necessarily know anything about the companies whose stocks I own (indirectly) and neither do the index fund managers — shares are bought and sold at market price. I’m relying on the fact that market-prices are established by active investors who do research into the various companies.
But really, I’m not an expert in most of the things I buy and don’t have to be–there are enough other buyers and sellers as well as reviewers pointing out strong and weak points of products which then get factored into the price I pay even though I might never read a review before buying.
Daniel
Feb 23 2022 at 7:22pm
Fair enough, there’s lots of room for relaxing assumptions, and really the analysis does great a lot of times even with the strictest assumptions.Still, my main point is that the logic of “people are imperfect, so don’t blame markets for bad outcomes” is akin to “people are imperfect, so don’t blame command options for bad outcomes.” Assume a can opener…
Jon Murphy
Feb 24 2022 at 11:10am
Not quite. Remember that the key question is “as compared to what?”
Madeleine
Feb 23 2022 at 12:05pm
High credit card interest rates are easy to explain: many people pay off the balance every month, and even more intend to. I don’t know what my interest rate is because it doesn’t matter.
David Seltzer
Feb 23 2022 at 12:53pm
Is this a question of opportunity cost? With zero rates from the banks, it takes little effort and time to accept the offer. As for 6% realtors commissions, it’s worth the trade-off to negotiate from 60k on a million dollar trade to something marginally better. BTW. I have been taking zero offers for years and buying dividend yielding utility stocks. Even with the 3% fee charged, I’ve done well enough on the risk arb. I use my SS income to retire the debt by the time the promotion has expired. Usually 15 months.
Alan Goldhammer
Feb 23 2022 at 5:22pm
Having purchased a condo and sold a house in the past two months, I can factually state that the realtor’s commission in both cases was 4.5%. I don’t think 6% is being charged any longer. In our case, the realtor was a family friend and he had great suggestions for prepping our house for sale. It was sold the first weekend it went on the market. Without going into the financial details, we got what we paid for and were very pleased in terms of the final sales price.
Luke J
Feb 23 2022 at 6:58pm
Doesn’t the efficient market hypothesis render price shopping moot? Why waste time looking for deals and negotiating a down commissions? I have other things to do.
Dzhaughn
Feb 25 2022 at 3:42am
Sure. However, there are (at least) two markets: one for those who are not willing to spend time shopping, and a second for those are price sensitive. If you shopped around more, you would notice this!
For instance, you could notice a rotation of discounted “sale” items at grocery stores, even for always-in-stock shelf-stable items like potato chips or boxes of cereal or soda. Or appliances. Or power tools. You might notice people talking about “deals” they negotiated when buying cars or boats.
And then you would notice the occasional absence of this pattern, particular in the most expensive brands.
Cf. “Customer segmentation.”
Jon Murphy
Feb 25 2022 at 12:05pm
Prices don’t just magically appear. They need actors in order to emerge.
Phil H
Feb 24 2022 at 5:16am
“markets… impossibly high standards… not the market, but the consumers, who have failed”
Way to give up the libertarian high ground. That would make markets exactly the same as government, then: perfect in theory, and if the practice fails, it’s definitely not my fault!
I disagree with the reasoning of the entire post, though. I’m not sure credit card prices should be lower: the credit card companies don’t seem to be making ridiculous profits. As for negotiation and shopping around, they’re both very costly in time and emotional effort. I happily pay money to avoid them.
James
Feb 24 2022 at 10:26am
“That would make markets exactly the same as government, then: perfect in theory, and if the practice fails, it’s definitely not my fault!”
Partly correct: Everything is perfect in theory and when it fails it is the fault of whoever is making the decisions.
But markets and government are not exactly the same. Bad decisions happen in both but they differ in magnitude and in reach. If a private company offers a good or service that you regard as stupid or overpriced, you are free not to buy until the company persuades you to do otherwise. If the government has a program that you regard as stupid or overpriced, you still have to fund it until the government decision makers are persuaded to do otherwise.
Dylan
Feb 24 2022 at 3:22pm
True in a lot of cases, but with plenty of exceptions. I don’t have the option to not be tracked by Facebook and have them build a profile on me, even though I’ve never had an account with them. I can’t opt-out of the credit agencies building a report on me. I don’t really have the option to not buy electricity, phone service, or internet…and there is many times only a single option for these services unless you move, which is also an option to escape government rules or regulations you find overly burdensome (at least local or state regulation, federal regulation is harder to get away from, since moving to a new country in incredibly difficult for most of us)
Jon Murphy
Feb 24 2022 at 3:56pm
Yes you do. If there is a profile out there claiming to be you, you should report it to Facebook immediately. It’s a scam that someone is perpetrating.
A good number of people live off the grid (and can live well). There’s lots of literature out there.
But NB: you do have lots of options for phone service. Cell phones destroyed local monopolies, and VOIP destroyed wireless monopolies.
Dylan
Feb 24 2022 at 6:42pm
Facebook collects information on people who have never signed up for the site and this information has been part of Facebook data breaches.
https://www.makeuseof.com/tag/facebook-shadow-profiles/
Jon Murphy
Feb 25 2022 at 12:05pm
Oh. A Facebook “shadow profile” is very different thing. That’s your buddy giving Facebook information about you. This is where things start to get really weird about who really owns what.
So both points remain: Facebook cannot track and create a profile without your consent. But you don’t really have a say in whether or not they get contact info because it’s your buddy that opts to share it.
joe bernstein
Feb 24 2022 at 12:59pm
another example: healthcare. and if you answer ‘price opacity’, recall that there is great price dispersion of even generic drugs, a market in which bargain-finding search tools (that may even give you a coupon too) will gladly snoop around for you.
Knut P. Heen
Mar 1 2022 at 10:36am
If you lend $1 each to 120 people and only 100 people pay back, you need a 20 percent interest rate to get your $120 back.
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