Site icon Econ Eye

The Credit Card Loan Market

EconEye Admin

The U.S. President has proposed an annual interest rate of no more than 10 percent on credit card loans. A senior executive at JPMorgan Chase considers the proposal a vain attempt to help low-income borrowers. The average market interest rate on credit card loans is 22%.— economist.com

The Unregulated Credit Card Loan Market

A 10% cap on credit card loans would only drive consumers toward less regulated, costlier alternatives.—cnn.com

NB: The market interest rate is the equilibrium interest rate.

Answer the following questions to check your understanding of the story.

The news clip describes a government policy that proposes which of the following in the market for credit card loans?

Wrong! - A price floor sets a legal minimum price, not a legal maximum price.  A production quota on the credit card loan market will limits the number of loans, not the interest rate. Deregulation removes government controls. This policy adds a government price control.

Well Done! - A price ceiling makes it illegal to charge a price above a specified level. Here, the interest rate (the price of borrowing) is capped at 10 percent.

Is this policy likely to achieve its intended objective of lowering the cost of borrowing in the market for credit card loans?

__________, because the interest rate is set __________ the prevailing average market interest rate of 22 percent.

Wrong! - An interest-rate ceiling set below the equilibrium rate is binding and does lower the legal cost of borrowing. If an interest-rate ceiling is set above the equilibrium interest rate, it is non-binding. Lenders are already charging less than the legal maximum, so the law has no effect.

That's Right! - Because 10 percent is below the equilibrium interest rate, the ceiling is binding and lowers the legal cost of borrowing

What will the outcome of this policy in the market for credit card loans?

Wrong! - An upward interest-rate adjustment is prevented by price-ceiling, so market forces cannot eliminate the shortage. A surplus arises under a binding price floor, not under a price ceiling. Interest-rate adjustment is prevented by price controls, so market forces cannot neither eliminate a surplus or a shortage.

Good Job! - At an interest rate of 10 percent, the quantity of credit demanded exceeds the quantity supplied and a shortage arises. An upward interest-rate adjustment is prevented by price-ceiling, so, market forces cannot eliminate the shortage.

Will the policy improve economic welfare (consumer surplus + producer surplus)?

The policy __________ economic welfare as the quantity of credit card loans traded __________ the efficient quantity.

Wrong! - A binding price ceiling reduces the quantity traded below the efficient quantity, not above it. This policy prevents the market from reaching the efficient quantity. Overprovision of credit reduces total economic welfare.

Correct! - Some borrowers are willing to borrow at more than 10 percent and lenders are willing to earn more than the legal maximum, but these mutually beneficial transactions do not occur. A deadweight loss arises, reducing economic welfare.

How will the credit card loans be allocated once this policy is implemented?

Credit card loans will be allocated by ___________ mechanism.

Wrong! - Those who apply first are not necessarily the first to receive a loan. The market price mechanism is blocked by the legal maximum interest rate. Majority rule is used to make public decisions, not to allocate private credit.

You're Right! - Credit is allocated by personal characteristics, especially ability to repay. Lower-income, higher-risk borrowers are charged higher interest rates, but because rates above 10 percent are illegal, banks lend only to higher-income, lower-risk borrowers.

Is the allocation method identified in question 5 and adopted as a result of policy identified in question 1 fair?

It is ____________ and ___________.

Wrong! - In the fair-results view, an outcome is unfair if it makes low-income people worse off, which this policy does. In the fair-rules view, an outcome is unfair when rules prevent voluntary exchange, which happens here.

That's Right! - It is unfair in the fair-rules view because the interest-rate ceiling prevents voluntary exchange between willing borrowers and willing lenders. It is unfair in the fair-results view because low-income borrowers lose access to credit and are made worse off.

Why will this policy expand unregulated and illegal markets for credit card loans?

Unregulated and illegal markets will emerge ______________.

Wrong! - Lenders are not required once the price ceiling is imposed. They can refuse to lend. The problem is a shortage of credit, not affordability. An illegal market arises when many borrowers face a shortage and turn to it. A surplus implies too few borrowers, leaving no basis for an illegal market.

You Are Correct! - Because mutually beneficial trades are prohibited in the legal market, they take place in an illegal market.

What will be the outcome in unregulated and illegal markets for credit card loans?

In the illegal market, the interest rate on credit card loans will ____________.

Wrong! - If lenders were willing to lend below 10 percent, they could do so legally and would not need to operate illegally. Illegal markets exist precisely because the legal ceiling does not apply to them. Illegal-market interest rates cannot fall below the ceiling; they must lie above it.

Well Done! - In the illegal market, the interest rates rise above the legal maximum as frustrated borrowers with higher willingness to pay seek loans.

Exit mobile version