December 14, 2009


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 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.

For an illustration, imagine a loan of $100 that has an APY interest rate of 12%. This means that at the end of a year, the balance of the loan is $112. Pretty simple. Now imagine a loan of $100 that has an APR interest rate of 12% (with interest compounding monthly). What APR of 12% means in this case is that you pay 1% per month. At the end of the first month, your balance is $101. But in the second month, that 1% is taken on $101, not $100. So your balance at the end of the second month is not $102, but slightly more, and so on and so on until at the end of the year, your balance is not $112 but $112.68.

Here’s a real-life example. Recently I bought a suit from Express, the clothing retail store (they make surprisingly good, reasonably priced men’s suits), and opened up a store credit card to save some money off the initial purchase. The first piece of mail I got for the credit card cited two numbers: an APR interest rate of 22.8%, and a “daily periodic rate” of 0.06246%.

I of course understand what these numbers mean. The daily rate, when multiplied by 365, equals the APR rate. But the real annual interest paid on the credit card, of course, is not the APR percentage. It’s the daily rate compounded on top of itself 365 days in a row, which ends up being around 25.6%, or about three percent more. This means that a person carrying a $100 balance (and believing that APR is actually what he or she pays) would expect to owe $123 in about a year. In reality, it grows to about $126.

Is this a big deal? Three bucks, after all, really isn’t that much money. But on the other hand, you have to consider the cumulative effect of not only the APR/APY thing, but all the similar types of marketing tools, collectively.

But before this, you have to ask whether or not people actually understand the interest rates they are paying. I was curious enough in this question that I actually did a survey about it. The survey population wasn’t of course a representative sample of the city, the state, or the country; I relied on an electronic survey among my friends (education and good looks heavily biased upwards), and a paper survey I handed out near my home in Brookline, MA (yes, I actually stood out on a street corner and handed out surveys). But even though the sample wasn’t representative, I still think the results I gathered were eye-opening.

Here’s what I asked, in addition to some background info:

Interest rates are sometimes quoted in APR, and other times quoted in APY. Do you know the difference between APR and APY? If so, explain the difference in the box below. If you don’t know the difference, just write “don’t know” in the box.

The proportion of people who could actually answer this question was remarkably low. Of the 34 people I found in Coolidge Corner, zero knew the difference between APR and APY, and less than a third had any idea whatsoever. Keep in mind that this is in the middle or Brookline, one of the most affluent, cultured, and well-educated neighborhoods of greater Boston; among the 34 respondents, 31 were college graduates, and 20 had gone to graduate school.

Among my non-MBA friends, the numbers were slightly better, but still ugly. About one-in-five (22%) answered the question correctly, with a slightly higher percentage (32%) mentioned compounding in their answers. More than half (59%) offered no guess. This is a group for which 87% had gone to grad school.

Predictably, the business school students were better, but still not great. Sloanies got the right answer just 30% of the time, and a big chunk (45%) said they didn’t know the difference.

You may not be that shocked by these results. I was a bit surprised that the numbers were so low, but then again, the very reason I did this exercise was to show that even highly educated people would have trouble with this question.

For two major reasons, the lack of understanding on how interest rates actually work is alarming. The first one is moral in nature. No matter how common or accepted it is, to me it just does not seem right that your credit card quotes your interest rate in APR to look small, when your bank quotes your savings account interest rate in APY to look big. (The same can be said, by the way, of accounting standards and the various ways that publicly-traded companies can value assets, depending on which method makes their balance sheets look better.)

But the second reason has to with pure economic value. Though the APR-quoted interest rate looks very close to the real compounded (APY) rate, and this difference may make little difference to a single consumer, I wonder about what the aggregate effects are for the 300 million or so living in this country, collectively. You’ve got a situation where Americans are constantly exposed to an immense amount of clever marketing and advertising methods, coupled with their apparent irrationality (not a uniquely American phenomenon of course), and then on top of this the not-really-honest-but-still-legal tools such as APR and APY interest rate quoting. Is it such a mystery, then, that Americans save so little and spend so much as compared to nearly every other wealthy country? To assume our nation’s savings rate is determined only by purely economic phenomena is, I think, a fantasy.

Let me end this by saying, as I’ve said before, that I am not in the “get the bankers” angry mob that thinks that the profit motive is the root of our current financial crisis. Nor is consumer credit a bad thing by any stretch; I recently read an article in Atlantic Magazine about Dave Ramsey, the evangelical finance guy who tells everyone to cut up their credit cards and eschew all debt. Ramsey is of course way over the top. In a recession especially, consumers need access to credit, and should not be hindered from getting liquidity, as long as they are making decisions that they are comfortable with, and they know what they are doing. The question is, do they always know what they are doing? Unfortunately the answer is no.

Instituting more requirements on credit cards and other financial products, like mandating clearer information or creating new standards on how that information is conveyed, may seem like a crippling shackle to these industries. But the point is not to maximize value to any industry, but maximize value in general. You can’t do that when consumer choices are purposefully distorted. And further, given the incredible level of distrust that the financial crisis has stirred up against these industries, doing away with the APR/APY dichotomy may be an important step towards dissolving some of the bitter uncertainty and skepticism among consumers, maybe even benefiting these industries in the long run (like a car dealer willingly disclosing a vehicle’s accident history, to earn a potential buyer’s trust).  Given the tenuous state of the economy as it stands, any ounce of added trust would be helpful to all of us.



  1. sahba said,

    Magnificent. Thank you, Eamon.

  2. saman said,

    there’s a professor at yale who’s written a lot lately about how we aren’t very rational, and herd mentality to explain recent events. i forget his name – do you know it?

    • Eamon Aghdasi said,

      Yes, you’re thinking of “Myth of the Rational Market” by Justin Fox. It’s gotten a lot of press but I haven’t read it yet.

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