Intermediate Microeconomics and Its Application 12th Edition by Walter Nicholson,Christopher Snyder

Exercise 15

Household Finance
Managing a household's finances seems like a simple task at first glance, but a closer look reveals substantial complexity. How much should parents save each year for their children's future college expenses? How much should they save for retirement and where should they invest the savings-a bank certificate of deposit, the stock market, or gold? Economists have investigated whether the average person is equipped with the basic math skills to answer such questions, whether people use those skills to plan for the future, and how close those plans come to what an expert financial advisor would suggest.
Financial Literacy
To test whether people have the basic math skills to make simple financial decisions, a survey asked questions such as the following: A bank account that pays 10% interest is opened with $200. How much would you have in the account after two years? Although readers of this book wouldn't have much difficulty with this question, the study found less than one fifth of the respondents answered it correctly.1 Without outside help (learning from smart neighbors, hiring expert financial planners, or reading good books on the subject), these results suggest that the average household may have trouble making the right financial decisions.
Retirement Planning
Further evidence from this study suggests that rather than seeking outside help for financial decisions, most people just throw up their hands. Among older respondents for whom retirement is a more salient issue, only a third had considered how much money they would need for retirement, and less than a fifth had come up with a savings plan. Financially literate respondents were better planners, and the better planners had accumulated more retirement wealth, even accounting for all the other characteristics (education, income, etc.) that might affect planning and wealth. Financial literacy appears to be a useful life skill that is perhaps too rare in the population
Car Loans
There is a common thread linking the difficulty the hero had in selecting the right prize offered by the queen in the text and the difficulty four fifths of the respondents had in answering the bank-account question above. Both calculations deal with compound growth, which is badly underestimated by the linear approximations people tend to use.
Victor Stango and Jonathan Zinman show that for any given stream of loan repayments, this bias in people's thinking leads them to underestimate the implied annual percentage interest rate (APR).2 Lenders have an incentive to fool consumers into taking high-interest rate loans for automobiles and other purchases by advertising low monthly payments. This strategy works because the same bias that makes the hero underestimate compound growth also makes borrowers underestimate how quickly loan principal balances decline. For example, for a five-year loan of $10,000, the average principal balance over the life of the loan is only about $5,000 because some principal is paid back with each monthly installment. The authors found that consumers who underestimated interest rates in hypothetical questions the most carried loans with worse terms (higher APRs) than others. What is more interesting is that they received the relatively higher APRs exactly when the government's enforcement of truth-in-lending regulations (requiring lenders to quote APRs in advertisements) was lax. One might think competition would drive high-interest lenders out of the market, but the complexity of loans (specifying monthly payments, interest rates, and repayment periods) may allow lenders to shroud high rates, making it hard for consumers to comparison shop.
One symptom of the recent U.S. economic crisis is the growing number of late mortgage payments and home foreclosures. Some blame predatory lenders, who induced naïve consumers to sign complicated contracts (involving adjustable rates, balloon payments, and other features) with unfavorable terms that the consumers did not understand. Read some newspaper accounts of the Mortgage Reform and Anti- Predatory Lending Act, introduced into the U.S. House of Representatives in March 2009. What are potential costs and benefits of this bill? How much of the foreclosure problem can be attributed to consumer naiveté versus an unexpected decline in economic conditions?