Consumer Credit with Over-Optimistic Borrowers

Florian Exler, Igor Livshits, James (Jim) MacGee () and Michèle Tertilt

Journal of the European Economic Association, 2025, vol. 23, issue 4, 1431-1478

Abstract: Do cognitive biases call for regulation to limit the use of credit? We incorporate over-optimistic and rational borrowers into an incomplete markets model with consumer bankruptcy. Over-optimists face worse income risk but incorrectly believe they are rational. Thus, both types behave identically. Lenders price loans forming beliefs—type scores—about borrower types. This gives rise to a tractable theory of type scoring. As lenders cannot screen types, borrowers are partially pooled. Over-optimists face cross-subsidized interest rates but make financial mistakes: borrowing too much and defaulting too little. In equilibrium, the welfare losses from mistakes are more than compensated by cross-subsidization. We calibrate the model to the United States and quantitatively evaluate policies to address these frictions: financial literacy education, reducing default cost, increasing borrowing costs, and debt limits. While some policies lower debt and filings, only reducing default costs and financial literacy education improve welfare. However, financial literacy education benefits only rationals at the expense of over-optimists. Score-dependent borrowing limits can reduce financial mistakes but lower welfare.

Date: 2025
References: Add references at CitEc
Citations:

Downloads: (external link)
http://hdl.handle.net/10.1093/jeea/jvae057 (application/pdf)
Access to full text is restricted to subscribers.

Related works:
Working Paper: Consumer Credit with Over-Optimistic Borrowers (2021)
Working Paper: Consumer Credit with Over-optimistic Borrowers (2020)
Working Paper: Consumer Credit With Over-Optimistic Borrowers (2020)
Working Paper: Consumer Credit with Over-Optimistic Borrowers (2020)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:oup:jeurec:v:23:y:2025:i:4:p:1431-1478.

Access Statistics for this article

Journal of the European Economic Association is currently edited by Romain Wacziarg

More articles in Journal of the European Economic Association from European Economic Association
Bibliographic data for series maintained by Oxford University Press ().