December 14, 2009

APRrrrrrr

Posted in Rationality and consumer choice at 1:20 am by Eamon Aghdasi

If you’ve been following this blog in the past couple months, you’ll know that I’m a pretty adamant critic of marketing and advertising methods which seem to prey on consumers’ lack of knowledge or judgment. This past summer I wrote an entry about this, in the context of advertising. The premise was that though classical economic models rest on the principle of rationality, recent research (and common sense) argues convincingly that people really don’t behave that rationally. (This is not an indictment of economics, which purposefully simplifies life to provide a useful model, but rather those people who get obsessed with these simplifying assumptions and begin to believe they actually play out in real life.)

If consumers aren’t really rational, I argued, then producers could find ways to exploit that lack of rationality with clever tricks and gimmicks. As I discussed earlier, if you don’t believe this is possible, just one piece of evidence is Bertrand et al’s experiment in South Africa, where men were shown to be significantly more likely to accept a loan offer when a woman’s face appeared on the promotional material. Behavior on the part of firms that targets consumers’ irrationality is so common, I argue, that we barely bat an eyelash at the bikini babes used to sell beer on TV, or asterisks on big “50% off!” signs with fine print at the bottom.

An ad from uvacreditunion.com. Few people, it seems, know the difference between APR and APY interest rates.

This type of behavior would be fine if the influence it has was distributed evenly across types of goods, but that is unfortunately not true. There are some industries or products for which such messages are enormously powerful, and others where they are not used at all. So you end up with a world where the consumption of things that can be effectively advertised with persuasion is too much, and the consumption of things that can’t is too little.

One industry that is great at this is credit cards. I don’t think credit card companies necessarily utilize the emotional cues that I talked about in my earlier post any more than any other industry. But they have mastered the art of confusing consumers and overwhelming them with seemingly impossible-to-understand information. One of the silver linings of the financial crisis (especially relating to subprime mortgages), I think, is that it raised awareness of the need to protect the consumer when it comes to personal finance.

Let’s look at one of the simplest and seemingly most innocuous examples of this: the clever use of APR and APY interest rate quoting standards. If you don’t know already, the principle difference between APR (annual percentage rate) and APY (annual percentage yield) is that the first one doesn’t count compounding in the number, while the second one does.

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