Firms may have better information about consumers’ prospects after purchase or contract or about the effective terms of the purchase/contract than consumers themselves do. Many firms also have the ability to shrink the gap between consumers’ beliefs and the effective terms of purchase/contract, either by adjusting consumers’ beliefs about the effective terms or by adjusting the terms to better correspond to consumers’ beliefs. I analyze the effects of a policy change that makes the firms potentially liable if the consumers’ beliefs do not correspond to the effective terms. I show that an introduction of such liability can improve both social welfare and consumer surplus, even if (actually, especially if) the market is perfectly competitive. I also show that the extent of the improvement depends on the relative magnitude of three factors following the introduction of the liability: 1) decrease in the gap between the beliefs and the effective terms of the contract, 2) decrease in output (increase in price), and 3) efficiency of administering the liability. I proceed to analyze data from the US credit card market and the US mortgage market, where similar liabilities were introduced – several large credit card issuers were unable to include mandatory arbitration clauses with class action provisions and the residential mortgage creditors became subject to a private cause of action in the case that they do not consider the consumer’s ability to (re)pay when originating the mortgage. I do not find a statistically significant output decrease (price increase) in either of the two cases, suggesting that the introductions of such liability improved both social welfare and consumer surplus. [NOTE: the analysis of the mortgage market is preliminary and the description of the results is based on different datasets than those that are described in the text. I will update the text (and, potentially, the results) based on the datasets described when they become publicly available around September 2015.]
Alexandrov, Alexei, Making Firms Liable for Consumers’ Mistaken Beliefs: Theoretical Model and Empirical Applications to the US Mortgage and Credit Card Markets (April 27, 2015).