Do Customers Learn from Experience? Evidence from Retail Banking | Management Science

Unshrouding: Evidence from Bank Overdrafts in Turkey

ABSTRACT Lower prices produce higher demand… or do they? A bank's direct marketing to holders of “free” checking accounts shows that a large discount on 60% APR overdrafts reduces overdraft usage, especially when bundled with a discount on debit card or autodebit transactions. In contrast, messages mentioning overdraft availability without mentioning price increase usage. Neither change persists long after the messages stop. These results do not square easily with classical models of consumer choice and firm competition. Instead, they support behavioral models where consumers underestimate and are inattentive to overdraft costs, and firms respond by shrouding overdraft prices in equilibrium.

Analyzing Bank Overdraft Fees with Big Data

In 2012, consumers paid $32 billion in overdraft fees, representing the single largest source of revenue for banks from demand deposit accounts during this period. Owing to consumer attrition caused by overdraft fees and potential government regulations to reform these fees, financial institutions have become motivated to investigate their overdraft fee structures. Banks need to balance the revenue generated from overdraft fees with consumer dissatisfaction and potential churn caused by these fees. However, no empirical research has been conducted to explain consumer responses to overdraft fees or to evaluate alternative pricing strategies associated with these fees. In this research, we propose a dynamic structural model with consumer monitoring costs and dissatisfaction associated with overdraft fees. We apply the model to an enterprise-level data set of more than 500,000 accounts with a history of 450 days, providing a total of 200 million transactions. We find that consumers heavily discount the future and potentially overdraw because of impulsive spending. However, we also find that high monitoring costs hinder consumers’ effort to track their balance accurately; consequently, consumers may overdraw because of rational inattention. The large data set is necessary because of the infrequent nature of overdrafts; however, it also engenders computational challenges, which we address by using parallel computing techniques. Our policy simulations show that alternative pricing strategies may increase bank revenue and improve consumer welfare. Fixed bill schedules and overdraft waiver programs may also enhance social welfare. This paper explains consumer responses to overdraft fees and evaluates alternative pricing strategies associated with these fees. The online appendices are available at https://doi.org/10.1287/mksc.2018.1106 .

Limited and Varying Consumer Attention: Evidence from Shocks to the Salience of Bank Overdraft Fees

Abstract. We explore dynamics of limited attention in the $35 billion market for checking overdrafts, using survey content as shocks to the salience of ove

The Red, the Black, and the Plastic: Paying Down Credit Card Debt for Hotels, Not Sofas

Using transaction data from a sample of 1.8 million credit card accounts, we provide the first field test of a major prediction of Prelec and Loewenstein’s theory of mental accounting: that consumers will pay off expenditure on transient forms of consumption more quickly than expenditure on durables. According to the theory, this is because the pain of paying can be offset by the future anticipated pleasure of consumption only when money is spent on consumption that endures over time. Consistent with this prediction, we found that repayment of debt incurred for nondurable goods is an absolute 10% more likely than repayment of debt incurred for durable goods. The strength of this relationship is comparable to an increment in 15 percentage points in the credit card annualized percentage rate. Our results have not only managerial implications for the structuring of financial transactions (e.g., that credit card customers should be given the option of paying off specific purchases) but also more general implications for exploiting variations in the pain of paying in incentive schemes aimed at customers and employees. This paper was accepted by Yan Chen, behavioral economics.

A Model of Mental Accounting and Reference Price Adaptation

Consumers possess a mental account that stores the worth of items purchased and yet to be consumed. Reference prices act as the book values of these items. Movements in the account—the comparison between the reference price and the price paid at entry, and the comparison between the benefit of consumption and the reference price at exit—yield hedonic benefits. The reference price is determined by a psychological process of adaptation to the price evoked by the trade. The model is integrative in that it explains a wide array of observed anomalies such as sunk-cost effects, payment depreciation, reluctance to trade, preference for prepayment, and the flat-rate bias. The model also generates new testable implications. This paper was accepted by James Smith, decision analysis.

The Red and the Black: Mental Accounting of Savings and Debt

In the standard economic account of consumer behavior the cost of a purchase takes the form of a reduction in future utility when expenditures that otherwise could have been made are forgone. The reality of consumer hedonics is different. When people make purchases, they often experience an immediate pain of paying, which can undermine the pleasure derived from consumption. The ticking of the taxi meter, for example, reduces one's pleasure from the ride. We propose a “double-entry” mental accounting theory that describes the nature of these reciprocal interactions between the pleasure of consumption and the pain of paying and draws out their implications for consumer behavior and hedonics. A central assumption of the model, which we call prospective accounting, is that consumption that has already been paid for can be enjoyed as if it were free and that the pain associated with payments made prior to consumption (but not after) is buffered by thoughts of the benefits that the payments will finance. Another important concept is coupling, which refers to the degree to which consumption calls to mind thoughts of payment, and vice versa. Some financing methods, such as credit cards, tend to weaken coupling, whereas others, such as cash payment, produce tight coupling. Our model makes a variety of predictions that are at variance with economic formulations. Contrary to the standard prediction that people will finance purchases to minimize the present value of payments, our model predicts strong debt aversion—that they should prefer to prepay for consumption or to get paid for work after it is performed. Such pay-before sequences confer hedonic benefits because consumption can be enjoyed without thinking about the need to pay for it in the future. Likewise, when paying beforehand, the pain of paying is mitigated by thoughts of future consumption benefits. Contrary to the economic prediction that consumers should prefer to pay, at the margin, for what they consume, our model predicts that consumers will find it less painful to pay for, and hence will prefer, flat-rate pricing schemes such as unlimited Internet access at a fixed monthly price, even if it involves paying more for the same usage. Other predictions concern spending patterns with cash, charge, or credit cards, and preferences for the earmarking of purchases. We test these predictions in a series of surveys and in a conjoint-like analysis that pitted our double-entry mental accounting model against a standard discounting formulation and another benchmark that did not incorporate hedonic interactions between consumption and payments. Our model provides a better fit of the data for 60% of the subjects; the discounting formulation provides a better fit for only 29% of the subjects (even when allowing for positive and negative discount rates). The pain of paying, we argue, plays an important role in consumer self-regulation, but is hedonically costly. From a hedonic perspective the ideal situation is one in which payments are tightly coupled to consumption (so that paying evokes thoughts about the benefits being financed) but consumption is decoupled from payments (so that consumption does not evoke thoughts about payment). From an efficiency perspective, however, it is important for consumers to be aware of what they are paying for consumption. This creates a tension between hedonic efficiency and what we call decision efficiency. Various institutional arrangements, such as financing of public parks through taxes or usage fees, play into this tradeoff. A producer developing a pricing structure for their product or service should be aware of these two conflicting objectives, and should try to devise a structure that reconciles them.

How Do Consumers Avoid Penalty Fees? Evidence from Credit Cards

Using data from multiple card issuers, we show that the most common penalty fee type incurred by credit card holders, late payment fees, declines sharply over the first few months of card life. This phenomenon is wholly due to some consumers adopting automatic payments after a late payment event, thereby insuring themselves against future late payment fees. Nonadopters, who remain on manual-only payments, experience an unchanged high likelihood of future fees, despite exhibiting ample levels of available liquidity. Our results show that heterogeneity in adopting account management features of financial products, such as automatic payments, is important for understanding who avoids financial mistakes. This paper was accepted by Gustavo Manso, finance.

What Do Consumers Really Pay on Their Checking and Credit Card Accounts? Explicit, Implicit, and Avoidable Costs

(May 2009)

Managing Mental Accounts: Payment Cards and Consumption Expenditures

Abstract Does mental accounting matter for total consumption expenditures? We exploit a unique setting in which individuals exogenously receive a new payment card, without requesting one. Using random variation in the time of receipt, we show that individuals temporarily increase total consumption expenditure by making purchases with the new card without reducing spending on the others. We do not observe a corresponding increase in indebtedness. Total consumption expenditure rises even for the least liquidity-constrained individuals. The evidence is consistent with consumers treating methods of payment as nonfungible budget categories, as suggested by models of mental accounting and narrow bracketing.

Managing Mental Accounts: Payment Cards and Consumption Expenditures

Does mental accounting matter for total consumption expenditures? We exploit a unique setting in which individuals exogenously received a new credit card, without requesting one. Using random variation in the time of receipt we show that individuals temporarily increase total consumption expenditure by making purchases with the new card without reducing spending on the others. We do not observe a corresponding increase in indebtedness. Total consumption expenditure rises even for the least liquidity-constrained individuals. The evidence is consistent with consumers treating methods of payment as nonfungible budget categories, as suggested by models of mental accounting and narrow bracketing.

Purchase Justifiability Drives Payment Choice: Consumers Pay with Card to Remember and Cash to Forget

AbstractAlthough consumers often have multiple payment methods at their fingertips, such as cash and credit/debit cards, prior research is silent on how consumers choose between them. We home in on a key element of purchase—purchase justifiability—that affects how consumers choose to pay. Analysis of 118,042 real-world purchases and six experiments reveals that when consumers are motivated to forget (vs. remember) a purchase because they see it as difficult (vs. easy) to justify, they have an increased preference to pay with cash (vs. card) because cards create a “paper/electronic trail” that aids memory retrieval. These payment preferences are strongest among consumers most likely to recall/track their card spending, and manifest only when card expenses are trackable. We reconcile our results with the classic effect of payment method on pain of paying and discuss implications for merchants and for financial institutions designing payment methods of the future.

The Effects of Prior Spending on Future Spending Decisions: The Role of Acquisition Liabilities and Payments

Research in mental accounting shows that prior spending influences a consumer's decision to make a new spending decision (Heath and Soll 1996, Soman 2001). In particular, greater spending in a particular category reduces the likelihood of further spending in that category. In the present research, we decompose “spending” into two distinct episodes—the acquisition liability episode during which a purchase is made accompanied by a commitment to pay (e.g., using a credit card) and the payment episode during which the consumer's wealth actually gets depleted (e.g., paying the credit card bill). Using a controlled laboratory experiment and real world data from a group of consumers, we replicate earlier findings that prior spending influences a pending spending decision, but also show that the location of both the acquisition liability episode and the payment episode play a role. Our results contribute to an understanding of the dynamic mental accounting of acquisition liability and actual outflows.

Timing to the Statement: Understanding Fluctuations in Consumer Credit Use

We show that consumers spend 15% more per day in the first week following the receipt of a credit card statement than in the days just prior to the statement. This increase in spending includes both an increase in the likelihood that they use the credit card in the first weeks following their statement and an increase in transaction amount on days they use the credit card. In contrast to the effect on credit card spending, debit card spending is unaffected by credit card statement issuance, suggesting that consumers are not simply switching among modes of payment. Our estimates are based on exogenous variation from bank-assigned statement dates. We propose and test several alternative explanations to this spending puzzle: optimization of the free float, salience effect of the credit card statement, mental accounting, liquidity constraints, and automatic payments. We find that the consumers most apt to spend early in the credit card cycle tend to be those who do not revolve balances and are not close to their credit limit. Thus, this paper documents a puzzle with mixed support for several alternative explanations. This paper was accepted by David Simchi-Levi, finance.

“Repayment-by-Purchase” Increases Consumer Debt Repayment

This article tests the effect of a novel credit card payment format—repayment-by-purchase—on consumers’ payments toward credit card debt. In contrast to typical balance repayment, where consumers make repayments relative to a total amount owed, repayment-by-purchase prompts consumers to select items (e.g., a Starbucks coffee) or categories of purchase (e.g., restaurant and café purchases) and to make payments toward their related debt. A field experiment first suggests that customers who opted into repayment-by-purchase paid 12.18% more toward their statement balance than a control group. Subsequently, five lab experiments show that consumers repaying-by-purchase increase repayment by an average of 22.47% over typical balance repayment. Process evidence suggests that these differences may be driven by repayment-by-purchase's power to increase purchase salience, which in turns increases perceptions of progress toward reducing debt. Consistent with this theory, the effect of repayment-by-purchase on bill repayment emerges regardless of whether consumers repay durable versus nondurable goods, and for specific items or categories of purchases, as long as the bill uses labels that are concrete enough to raise past purchase salience.

Why Do Shoppers Use Cash? Evidence from Shopping Diary Data

Recent studies find that cash remains the dominant payment choice for small‐value transactions despite the prevalence of alternative payment methods such as debit and credit cards. An important policy question is whether consumers truly prefer using cash or merchants restrict card usage. Using unique shopping diary data, we estimate a payment choice model with individual heterogeneity, controlling for merchants' acceptance of cards. Based on a policy simulation imposing universal card acceptance among merchants, we find that overall cash usage would decrease by only 8.0 percentage points, implying that cash usage in small‐value transactions is driven mainly by consumer preferences.

Payment Depreciation: the Behavioral Effects of Temporally Separating Payments From Consumption

Abstract. Research suggests that individuals mentally track the costs and benefits of a consumer transaction for the purpose of reconciling those costs and