Privacy1
Paul Heidhues1
1 European
Botond Kőszegi2
School of Management and Technology
2 Central
European University
UCL October 17, 2014
1
This talk is based largely on the paper “Using Information about Naivete to
Price Discriminate”.
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Customer Information
Firms having access to more information is often good in classical
settings.
• First degree price discrimination maximizes welfare for any given
industry structure (Stole 2007).
• In (perfectly) competitive markets, firms having more information
about customers does not hurt them.
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Customer Information
Firms having access to more information is often good in classical
settings.
• First degree price discrimination maximizes welfare for any given
industry structure (Stole 2007).
• In (perfectly) competitive markets, firms having more information
about customers does not hurt them.
Caveats to the above.
• Security risks.
• Reclassification risk.
• Absent competition, may allow price discrimination potentially
detrimental to consumers (and perhaps welfare).
• ....
2 / 15
Customer Information
Firms having access to more information is often good in classical
settings.
• First degree price discrimination maximizes welfare for any given
industry structure (Stole 2007).
• In (perfectly) competitive markets, firms having more information
about customers does not hurt them.
Caveats to the above.
• Security risks.
• Reclassification risk.
• Absent competition, may allow price discrimination potentially
detrimental to consumers (and perhaps welfare).
• ....
This talk: there is an important, novel channel of why better customer
information may be bad in competitive environments.
• Ever more detailed information allows firm to better target
consumer mistakes.
2 / 15
Customer Information
Firms having access to more information is often good in classical
settings.
• First degree price discrimination maximizes welfare for any given
industry structure (Stole 2007).
• In (perfectly) competitive markets, firms having more information
about customers does not hurt them.
Caveats to the above.
• Security risks.
• Reclassification risk.
• Absent competition, may allow price discrimination potentially
detrimental to consumers (and perhaps welfare).
• ....
This talk: there is an important, novel channel of why better customer
information may be bad in competitive environments.
• Ever more detailed information allows firm to better target
consumer mistakes.
Requiring consent for information use need not help naive customers.
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Is Naivete-Based Discrimination Going On?
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Is Naivete-Based Discrimination Going On?
Some direct evidence suggests yes.
• Gurun, Matvos, and Seru (2013): lenders targeted minorities and
less educated consumers with expensive mortgages.
• Ru and Schoar (2014): US credit-card issuers target less educated
consumers with offers featuring more fees and long-term interest.
3 / 15
Is Naivete-Based Discrimination Going On?
Some direct evidence suggests yes.
• Gurun, Matvos, and Seru (2013): lenders targeted minorities and
less educated consumers with expensive mortgages.
• Ru and Schoar (2014): US credit-card issuers target less educated
consumers with offers featuring more fees and long-term interest.
Economic logic says yes.
3 / 15
Is Naivete-Based Discrimination Going On?
Some direct evidence suggests yes.
• Gurun, Matvos, and Seru (2013): lenders targeted minorities and
less educated consumers with expensive mortgages.
• Ru and Schoar (2014): US credit-card issuers target less educated
consumers with offers featuring more fees and long-term interest.
Economic logic says yes.
• Many behavioral IO theories predict that naive consumers are more
profitable.
3 / 15
Is Naivete-Based Discrimination Going On?
Some direct evidence suggests yes.
• Gurun, Matvos, and Seru (2013): lenders targeted minorities and
less educated consumers with expensive mortgages.
• Ru and Schoar (2014): US credit-card issuers target less educated
consumers with offers featuring more fees and long-term interest.
Economic logic says yes.
• Many behavioral IO theories predict that naive consumers are more
profitable.
• There are predictable differences in the frequency of financial
mistakes in different parts of the population.
3 / 15
Is Naivete-Based Discrimination Going On?
Some direct evidence suggests yes.
• Gurun, Matvos, and Seru (2013): lenders targeted minorities and
less educated consumers with expensive mortgages.
• Ru and Schoar (2014): US credit-card issuers target less educated
consumers with offers featuring more fees and long-term interest.
Economic logic says yes.
• Many behavioral IO theories predict that naive consumers are more
profitable.
• There are predictable differences in the frequency of financial
mistakes in different parts of the population.
• Incentive to acquire information + capacity to acquire information
⇒ firms already do it, or soon will.
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Basic Credit-Market Model
Setup:
• N ≥ 2 risk-neutral lenders interact with consumers over three
periods.
• Lenders have access to funds at zero interest.
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Basic Credit-Market Model
Setup:
• N ≥ 2 risk-neutral lenders interact with consumers over three
periods.
• Lenders have access to funds at zero interest.
• In period 0, lenders offer contracts (b, r , d) where
• b is loan amount
• r is interest rate
• d a discount (e.g price reduction for store credit or credit-card perk)
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Basic Credit-Market Model
Setup:
• N ≥ 2 risk-neutral lenders interact with consumers over three
periods.
• Lenders have access to funds at zero interest.
• In period 0, lenders offer contracts (b, r , d) where
• b is loan amount
• r is interest rate
• d a discount (e.g price reduction for store credit or credit-card perk)
• Borrowers decide whether and which contract to accept.
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Basic Credit-Market Model
Setup:
• N ≥ 2 risk-neutral lenders interact with consumers over three
periods.
• Lenders have access to funds at zero interest.
• In period 0, lenders offer contracts (b, r , d) where
• b is loan amount
• r is interest rate
• d a discount (e.g price reduction for store credit or credit-card perk)
• Borrowers decide whether and which contract to accept.
• In period 1, a borrower chooses the amount q to repay in that
period; the remainder is paid back with interest in period 2.
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Credit-Market Model
Preferences:
• Borrowers have time inconsistent preferences:
• Self 0’s utility trades off the utility from borrowing u(b) and the
discount with the total repayment costs.
• Self 1 down-weights repayment costs in period 2 by a factor β < 1.
• The utility from borrowing is increasing and strictly concave, and
borrowers are prudent (u 000 (b) ≥ 0).
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Credit-Market Model
Preferences:
• Borrowers have time inconsistent preferences:
• Self 0’s utility trades off the utility from borrowing u(b) and the
discount with the total repayment costs.
• Self 1 down-weights repayment costs in period 2 by a factor β < 1.
• The utility from borrowing is increasing and strictly concave, and
borrowers are prudent (u 000 (b) ≥ 0).
Beliefs:
• All borrowers believe that self 1 discounts period-2 payments by β̂.
• Sophisticated borrowers discount according to β̂.
• Naive borrowers discount with factor β < β̂.
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Credit-Market Model
Preferences:
• Borrowers have time inconsistent preferences:
• Self 0’s utility trades off the utility from borrowing u(b) and the
discount with the total repayment costs.
• Self 1 down-weights repayment costs in period 2 by a factor β < 1.
• The utility from borrowing is increasing and strictly concave, and
borrowers are prudent (u 000 (b) ≥ 0).
Beliefs:
• All borrowers believe that self 1 discounts period-2 payments by β̂.
• Sophisticated borrowers discount according to β̂.
• Naive borrowers discount with factor β < β̂.
• Firms (correctly) believe a share α is naive.
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Credit-Market Model
Preferences:
• Borrowers have time inconsistent preferences:
• Self 0’s utility trades off the utility from borrowing u(b) and the
discount with the total repayment costs.
• Self 1 down-weights repayment costs in period 2 by a factor β < 1.
• The utility from borrowing is increasing and strictly concave, and
borrowers are prudent (u 000 (b) ≥ 0).
Beliefs:
• All borrowers believe that self 1 discounts period-2 payments by β̂.
• Sophisticated borrowers discount according to β̂.
• Naive borrowers discount with factor β < β̂.
• Firms (correctly) believe a share α is naive.
Equilibrium:
• The equilibrium is a contract that earns zero profits and for which
there exists no other contract that consumers strictly prefer that
earns positive profits.
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Naivete-Based Price Discrimination
Main question of paper:
• Initially, there is a pool of borrowers with a share αns of naive
consumers.
• Suppose lenders can sort borrowers into two pools with shares
αn > αns and αs < αns of naive consumers, and offer different
contracts to them.
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Naivete-Based Price Discrimination
Main question of paper:
• Initially, there is a pool of borrowers with a share αns of naive
consumers.
• Suppose lenders can sort borrowers into two pools with shares
αn > αns and αs < αns of naive consumers, and offer different
contracts to them.
• How does this affect social welfare?
Extreme case: perfect naivete-based price discrimination, where
αn = 1, αs = 0.
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Characterizing the Competitive Equilibrium
• There is some maximal interest rate for which naive borrowers delay
repayment.
• At this interest rate, sophisticated borrowers who are less
time-inconsistent repay the loan early and
• ...naive borrowers believe when signing the contract that they will
repay early.
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Characterizing the Competitive Equilibrium
• There is some maximal interest rate for which naive borrowers delay
repayment.
• At this interest rate, sophisticated borrowers who are less
time-inconsistent repay the loan early and
• ...naive borrowers believe when signing the contract that they will
repay early.
• Inducing inefficient extra borrowing allows firms to collect a higher
unanticipated repayment from naive consumers.
• The equilibrium contract trades off this benefit to the lender with the
efficiency cost of inefficient overborrowing.
• The more naive borrowers, the higher the benefit from inducing an
extra unit of overborrowing.
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Characterizing the Competitive Equilibrium
• There is some maximal interest rate for which naive borrowers delay
repayment.
• At this interest rate, sophisticated borrowers who are less
time-inconsistent repay the loan early and
• ...naive borrowers believe when signing the contract that they will
repay early.
• Inducing inefficient extra borrowing allows firms to collect a higher
unanticipated repayment from naive consumers.
• The equilibrium contract trades off this benefit to the lender with the
efficiency cost of inefficient overborrowing.
• The more naive borrowers, the higher the benefit from inducing an
extra unit of overborrowing.
• Hence, social welfare is decreasing in the share of naive consumers.
• Sophisticated consumers’ utility, however, is increasing in the share of
naive consumers as they are cross-subsidized.
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The Welfare Effect of Lender Information
Proposition
For any αns , αn , αs , seller information about consumer naivete lowers
welfare.
• With information, lenders increase the overlending in the pool with
more naive borrowers, and decrease it in the pool with more
sophisticated ones.
• The former, welfare-decreasing effect, outweighs the later:
• First: Since u is concave, an increase in lending to borrowers by a
given amount hurts social welfare more than an equal decrease in
lending raises social welfare.
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The Welfare Effect of Lender Information
Proposition
For any αns , αn , αs , seller information about consumer naivete lowers
welfare.
• With information, lenders increase the overlending in the pool with
more naive borrowers, and decrease it in the pool with more
sophisticated ones.
• The former, welfare-decreasing effect, outweighs the later:
• First: Since u is concave, an increase in lending to borrowers by a
given amount hurts social welfare more than an equal decrease in
lending raises social welfare.
• Second: with prudence, overall lending increases.
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The Welfare Effect of Lender Information
Multiple Naive Types
• Suppose there are I types for with β1 < β2 < · · · < βI = β̂.
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The Welfare Effect of Lender Information
Multiple Naive Types
• Suppose there are I types for with β1 < β2 < · · · < βI = β̂.
• If type i is indifferent between delaying or not, all lower types strictly
prefer to delay.
• Tradeoff: a lower interest rate leads more types to delay, but a lender
earns less per borrower who does so.
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The Welfare Effect of Lender Information
Multiple Naive Types
• Suppose there are I types for with β1 < β2 < · · · < βI = β̂.
• If type i is indifferent between delaying or not, all lower types strictly
prefer to delay.
• Tradeoff: a lower interest rate leads more types to delay, but a lender
earns less per borrower who does so.
• Lenders chooses naive type i to maximize unanticipated repayment.
9 / 15
The Welfare Effect of Lender Information
Multiple Naive Types
• Suppose there are I types for with β1 < β2 < · · · < βI = β̂.
• If type i is indifferent between delaying or not, all lower types strictly
prefer to delay.
• Tradeoff: a lower interest rate leads more types to delay, but a lender
earns less per borrower who does so.
• Lenders chooses naive type i to maximize unanticipated repayment.
• If lender information does not change the optimal type i to target in
either pool, intuition is as before.
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The Welfare Effect of Lender Information
Multiple Naive Types
• Suppose there are I types for with β1 < β2 < · · · < βI = β̂.
• If type i is indifferent between delaying or not, all lower types strictly
prefer to delay.
• Tradeoff: a lower interest rate leads more types to delay, but a lender
earns less per borrower who does so.
• Lenders chooses naive type i to maximize unanticipated repayment.
• If lender information does not change the optimal type i to target in
either pool, intuition is as before.
• Otherwise, firms can tailor the interest rate to each pool, increasing
the amount of unanticipated interest per borrower, which in turn
increases overlending and thereby further decreases social welfare.
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The Welfare Effect of Lender Information
Heterogeneity in Beliefs: Setup
• We allow for two possible belief types, β̂1 < β̂2 . (Paper allows for
more types.)
• For each belief type borrowers are either sophisticated β = β̂i or
naive β = βi . We suppose β1 < β̂1 ≤ β2 ≤ β̂2 .
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The Welfare Effect of Lender Information
Heterogeneity in Beliefs: Setup
• We allow for two possible belief types, β̂1 < β̂2 . (Paper allows for
more types.)
• For each belief type borrowers are either sophisticated β = β̂i or
naive β = βi . We suppose β1 < β̂1 ≤ β2 ≤ β̂2 .
• A competitive equilibrium is a set of contracts, and masses of
consumers accepting individual contracts that satisfy:
•
•
•
•
Borrower optimization.
Contracts on average earn zero profits.
No profitable deviation.
(Non-redundancy: all contracts are accepted by someone.)
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The Welfare Effect of Lender Information
Heterogeneity in Beliefs: Preliminary Result
The unique competitive equilibrium is fully separating, with borrowed
amount and interest rate for each belief type β̂i equal to those in the
observable case, and the equilibrium discount appropriately adjusted.
• Rational:
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The Welfare Effect of Lender Information
Heterogeneity in Beliefs: Preliminary Result
The unique competitive equilibrium is fully separating, with borrowed
amount and interest rate for each belief type β̂i equal to those in the
observable case, and the equilibrium discount appropriately adjusted.
• Rational:
• More patient consumers get a weakly higher utility from any contract.
• If the contracts with observable beliefs give belief-type β̂2 a higher
perceived utility, this is the competitive equilibrium. The belief-type
β̂1 prefers not to take the contract designed for the higher type
because she realizes that she will break down and act as a naive agent
in that contract.
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The Welfare Effect of Lender Information
Heterogeneity in Beliefs: Preliminary Result
The unique competitive equilibrium is fully separating, with borrowed
amount and interest rate for each belief type β̂i equal to those in the
observable case, and the equilibrium discount appropriately adjusted.
• Rational:
• More patient consumers get a weakly higher utility from any contract.
• If the contracts with observable beliefs give belief-type β̂2 a higher
perceived utility, this is the competitive equilibrium. The belief-type
β̂1 prefers not to take the contract designed for the higher type
because she realizes that she will break down and act as a naive agent
in that contract.
• If, however, with observable beliefs the perceived utility is greater for
belief-type β̂1 , then belief-type β̂2 prefers that contract and
equilibrium utilities must be “ironed out” so that higher types get a
higher utility.
• But if each belief-type does not receive the borrowed amount and
interest rate that optimally exploits it given beliefs, a lender can
introduce a profitable deviation that optimally exploits.
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The Welfare Effect of Lender Information
Heterogeneity in Beliefs: Result
• Since total social welfare depends only on amount borrowed and the
repayment profile, lender information weakly lowers social welfare.
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The Welfare Effect of Lender Information
Heterogeneity in Beliefs: Result
• Since total social welfare depends only on amount borrowed and the
repayment profile, lender information weakly lowers social welfare.
• If for all β̂i the share of naive consumers is the same in both pools,
lender information does not affect social welfare.
• Since agents self-select according to their belief type anyhow,
information that is purely about agents’ belief-type does not affect
social welfare.
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The Welfare Effect of Lender Information
Heterogeneity in Beliefs: Result
• Since total social welfare depends only on amount borrowed and the
repayment profile, lender information weakly lowers social welfare.
• If for all β̂i the share of naive consumers is the same in both pools,
lender information does not affect social welfare.
• Since agents self-select according to their belief type anyhow,
information that is purely about agents’ belief-type does not affect
social welfare.
• If for any β̂i , the share of naive consumers differs across pools,
lender information strictly lowers social welfare.
• This information helps to predict how an agent behaves ones the
contract is signed.
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The Welfare Effect of Lender Information
Heterogeneity in Beliefs: Result
• Since total social welfare depends only on amount borrowed and the
repayment profile, lender information weakly lowers social welfare.
• If for all β̂i the share of naive consumers is the same in both pools,
lender information does not affect social welfare.
• Since agents self-select according to their belief type anyhow,
information that is purely about agents’ belief-type does not affect
social welfare.
• If for any β̂i , the share of naive consumers differs across pools,
lender information strictly lowers social welfare.
• This information helps to predict how an agent behaves ones the
contract is signed.
• We also illustrate in the paper that for welfare to decrease it is
neither necessary nor sufficient for firms to learn about ex-post
preferences.
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The Welfare Effect of Lender Information
Consumer Consent
• We consider the impact of requiring the agreement of consumers for
firms to analyze and sell their data; suppose the data fully reveal a
consumer’s type.
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The Welfare Effect of Lender Information
Consumer Consent
• We consider the impact of requiring the agreement of consumers for
firms to analyze and sell their data; suppose the data fully reveal a
consumer’s type.
• Consumers can give their data to one of two “information firms” in
exchange for some payment.
• Information firms can sell the customer data to a given lender.
• Uninformed lenders make uninformed credit-contract offers to
borrowers.
• The informed lender, upon observing the uninformed offer, can make
a targeted contract offer.
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The Welfare Effect of Lender Information
Consumer Consent
Key insights:
• Because a consumer thinks she is sophisticated, she thinks that the
lender having information will not hurt.
• Upon getting the information, a lender fully exploits the consumer’s
naivete.
• Uninformed lenders offer the sophisticated contract since they
cannot compete against a better informed rival.
• Informed lender earns a rent equal to the expected profit of
optimally exploiting a naive borrower; but in competition pays this
to the information firm.
• Competition among the information firms ensures that this rent is
handed over to consumers.
• So this “consent game” maximizes sophisticated consumers’ welfare,
and at the same time minimizes social welfare.
• More generally, requiring consent benefits sophisticated consumers
but does not protect naive consumers or increases social welfare.
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Regulatory Implications
• Regulators should think about what kind of information firms
acquire.
• Conventional wisdom regarding information about preferences does
not carry over to information about naivete.
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Regulatory Implications
• Regulators should think about what kind of information firms
acquire.
• Conventional wisdom regarding information about preferences does
not carry over to information about naivete.
• Firms have an incentive to target information that naive consumers
think is harmless to pass on.
• Consent is not helpful if they do so.
• Need a model of naivete in the relevant market and how it interacts
with consent.
• Careful if just ruling out the use of certain information. Firms may
use other proxies.
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