Instructions:
Introduction:
The Micro Essay part of the 1993 Economics Comprehensive Exam will test your knowledge of microeconomic theory by asking a series of questions about lending/borrowing money and today's credit card market.
Much of the information contained herein is taken from Lawrence Ausubel, "The Failure of Competition in the Credit Card Market," American Economic Review, Vol 81 (1), March 1991, pp. 50-81. Ausubel's thesis is that although some 4000 firms compete in an environment lacking regulatory or other significant barriers, the credit card market does not behave as the perfectly competitive model predicts.
Ausubel writes:
Credit cards are the currency of late 20th-century America. The aggregate charge volume on plastic in the United States was estimated at $375 billion in 1987.* Almost half of this total -- $165 billion in volume -- was charged on MasterCard and Visa credit cards (the primary focus of this article), and volume was growing at well over 10 percent per year.** The remaining volume arose largely from similar credit cards (e.g., the Discover and Optima cards), "travel and entertainment cards" (e.g., the American Express card), and retail cards (e.g., department store and oil company credit cards).
* Moreover, Americans were estimated to have made 9.1 billion credit card transactions in 1987.
** U.S. volume in 1987 consisted of $138 billion in sales slips (i.e., charged goods and services) and $27 billion in cash advances.Visa accounted for 59% of this value and MasterCard accounted for the remaining 41%.A Microeconomic Analysis of Borrowing:
Before we examine why consumers borrow through credit cards, we must ask the more fundamental question of why they borrow at all!
The question is: "Why do people borrow money?"
The answer, obviously, is because borrowing increases satisfaction by shifting consumption from the future to the present.
Let's anaylze borrowing with a two period model. Suppose an individual chooses how much of a composite good, C, to consume in each of two time periods. We denote the amount of consumption in each period by C1 and C2. The individual gets satisfaction (or utility) from consumption in each period which can be represented by an indifference map. The individual has an initial endowment of income in each period with which to purchase the composite good (assumed to have a constant price=$1/unit in both periods). The individual's incomes in periods 1 and 2 are denoted by M1 and M2. Finally, the consumer can borrow or lend money at some interest rate, r.
Thus, in this model, the budget constraint is
C2 = M2 + (M1 - C1) + r(M1 - C1)
= M2 + (1 + r)(M1 - C1)
Thus, the slope of the budget constraint is -(1+r).
The budget constraint equation tells us the individual's consumption possibilities.
SAVER: If the individual is a saver in period 1, then the amount consumed in period 2 (C2) is equal to the money available in period 2 (M2) plus the saved principal (M1 - C1) plus the interest gained on the savings (r(M1 - C1)).
BORROWER: If, on the other hand, the individual is a borrower, then the amount consumed in period 2 (C2) is equal to the money available in period 2 (M2) minus the borrowed money (-(C1 - M1) = M1 - C1) minus the interest paid on the debt (-r(C1 - M1) = r(M1 - C1)).
Note that (M1 - C1) is positive for savers and negative for borrowers.
The important point about borrowing (i.e., consuming more than your earned income in period 1) and saving (i.e., consuming less than your earned income in period 1) is that these moves are done in order to increase satisfaction. The individual is faced with a constrained optimization problem,
max U = Ÿ(C1, C2)
s.t. budget constraint
By choosing C1* and C2*, the amount of borrowing or saving can then be determined.
Perhaps a graph would help . . . FIGURE 1 below shows a situation in which the consumer is a borrower:
FIGURE I: A Borrower's Constrained Optimization Problem
In FIGURE 1 above, M1 and M2 are the incomes earned in each period. The individual can, however, by borrowing or saving in period 1, consume more or less in period 1 than the amount M1 which he earned in period 1. C1 indicates the amount of consumption in period 1 -- if C1 is to the right (left) of M1 in FIGURE I, the individual is a borrower (saver). C1* indicates not just any level of consumption in period 1, but the optimal level of consumption in period 1. Thus, M1 - C1* is the optimal level of saving/borrowing (depending, of course, on whether M1 - C1* is positive or negative).
QUESTION 1: Understanding the Model
(5 PTS) (1A) The individual in FIGURE I borrowed M1 - C1*. What is the amount he must repay?
(5 PTS) (1B) "Given a positive interest rate, the individual must always repay more in period 2 than the amount borrowed in period 1."
True or false? Explain.
QUESTION 2: More Practice with the Model
(10 PTS) (2) Draw a graph of an individual who is a SAVER. Indicate, as in FIGURE I, the amount saved.
Carefully label all axes, curves, and points, as in FIGURE I.
QUESTION 3: Comparative Statics -- The Demand Curve for Loans
Let's return now to the individual who is a borrower. If the interest rate changes, the budget constraint will pivot around the initial endowment -- the budget constraint WILL NOT pivot around the y-intercept as in the "conventional" model.
(10 PTS) (3) Given this bit of information, derive graphically a downward sloping demand curve for borrowed (or loanable) funds.
NOTE: Two points on the demand curve is sufficient.
HINT: Carefully reproduce FIGURE I in your blue book, then examine the effect of a change in the interest rate on the amount borrowed (NOT the amount consumed in Period 1). Finally, record the interest rate, optimal borrowing combinations on a graph in r-Loans space below the reproduced graph of the borrower (i.e., FIGURE I).
QUESTION 4: Elasticity
It turns out that, in many loanable funds markets, quantities supplied and demanded are quite inelastic given changes in the interest rate. For example, credit card borrowers are very UNresponsive to changes in the interest rate.
(4 PTS) (4A) Similarly, the interest rate elasticity of saving has been estimated to be 0.1 (one-tenths). What does this mean?
(3 PTS) (4B) Use FIGURE II below to calculate the interest rate elasticity of demand for loanable funds at r=20%, Loanable Funds=$100.
FIGURE II: A Demand Curve for Loanable Funds
NOTE: You may use either an arc or point elasticity measure.
(3 PTS) (4C) How do the units on the slope of the demand curve differ from the units on the elasticity of demand?
QUESTION 5: A General Equilibrium Analysis
The Edgeworth-Bowley Box below describes an initial situation:
FIGURE III: A General Equilibrium Analysis of Loanable Funds
The height of the box shows consumption in period 2, while the length shows period 1 consumption. C2B indicates the Borrower's Consumption in Period 2. Finally, the Saver, in the above box, could also be called the Lender in period 1.
(5 PTS) (5A) Given FIGURE III above, is the prevailing interest rate (corresponding to the drawn in budget constraint/price vector) the equilibrium interest rate? Why or why not?
(5 PTS) (5B) Assuming a perfectly competitive market, will the interest rate change? If so, how? If not, why not?
QUESTION 6: Efficiency as Pareto Optimality
Economists spend much time and effort judging the results of particular allocation schemes. A fundamental concept in the evaluation of a particular allocation is that of Pareto Optimality.
(10 PTS) (6) What does Pareto Optimality mean, in this example concerning borrowing and lending, and why do economists worry about getting to such a point?
A general definition of Pareto Optimality is NOT sufficient here. Apply the definition to this particular case concerning borrowing and lending money.
QUESTION 7: Partial Equilibrium Analysis -- The Market for Loanable Funds
Let's suppose we have a perfectly competitive loanable funds market. Market demand and supply curves for loans indicate that some people want to borrow money and others want to save money. The savers, through banks and other financial intermediaries, make credit available for potential borrowers. Competition in this perfectly competitive market will lead to the establishment of an equilibrium interest rate and this interest rate will lead to the exchange of an equilibrium amount of loans.
FIGURE IV: A Supply and Demand Analysis of Loanable Funds
FIGURE IV above shows the perfectly competitive equilibrium solution when the (inverse) Demand for Loanable Funds is given by r = 30 - 2*LF and the (inverse) Supply of Loanable Funds is given by r = 2*LF.
(10 PTS) (7) If the interest rate were 20%, how might the market process work its way toward the perfectly competitive equilibrium?
QUESTION 8: Regulation
Suppose that Congress places a 10% ceiling on the interest rate on the perfectly competitive market described by FIGURE IV.
(5 PTS) (8A) Draw a carefully labelled graph depicting the deadweight loss resulting from the interest rate ceiling. Explain what the deadweight loss is.
(5 PTS) (8B) Who would benefit and who would lose from the interest rate ceiling? Explain why.
QUESTION 9: Ausubel's Empirical Findings
The market for credit card loanable funds can be modelled just like the market for loanable funds in general. Given a demand and supply for credit card loans, we should expect competition to drive the interest rate of credit cards to its equilibrium level. However, Ausubel argues that doesn't seem to be happening:
The cost of funds is obviously the primary determinant of the marginal cost of lending via credit cards, and it is usually the only component of marginal cost that varies widely from quarter to quarter. Thus, a model of continuous spot equilibrium [i.e., supply and demand in equilibrium over time] would predict a substantial degree of connection between the interest rate charged on credit cards and the banks' cost of funds. However, Figure 1 [below], which compares credit card interest rates with the cost of funds, displays stark empirical rejection of this prediction. [emphasis added] Credit card interest rates were highly sticky during the period 1982-1989 and, in fact, were virtually constant.
(10 PTS) (9) Given a perfectly competitive market, why should there be "a substantial degree of connection between the interest rate charged on credit cards and the banks' cost of funds"?
SEE THE HINT ON THE NEXT PAGE!
HINT: FIGURE 5 below shows a representative firm in the credit card industry:
FIGURE V: Initial Equilibrium
Assume each firm and the market to be in equilibrium in the first quarter of 1982; thus, from Ausubel's Figure 1, the equilibrium interest rate is 18% and the banks' cost of funds is 15%.
Now, determine how a perfectly competitive market would respond to changes in the banks' cost of funds.
Remember the question:
Given a perfectly competitive market, why should there be "a substantial degree of connection between the interest rate charged on credit cards and the banks' cost of funds"? QUESTION 10: Real World Policy Decisions
The stickiness of credit card interest rates is a really big deal! In the recent past, credit card issuers have enjoyed a relatively unencumbered business environment. Ausubel reports that, before 1978, credit card issuers were constrained by state usury laws. That year, however, in Marquette National Bank v. First of Omaha Service Corporation, the U.S. Supreme Court ruled that only the usury ceiling of that state in which the credit card issuer is located (and not the interest rate laws of the state where the consumer lives) restricts the interest rate the credit card company may charge. South Dakota and Delaware quickly established themselves as attractive homes-away-from-home for credit card issuers by repealing their usury laws and many other states have since followed suit. But the downwardly sticky interest rates have raised a storm of protest and have many calling for re-regulation of the credit card industry. The Wall Street Journal's response to sticky interest rates is to do nothing : "Credit-card interest almost certainly will come down. It will come down without rate ceilings. Nothing does it like competition." (WSJ, March 16, 1987).
(5 PTS) (10A) Why do economists worry about the stickiness of interest rates?
(5 PTS) (10B) Given the empirical observations presented by Ausubel, your
understanding of economic theory, and your personal values, would you support a general policy of regulation or laissez-faire in today's credit card loanable funds market? BRIEFLY discuss the key factors in determining your position.