Abstract: Why do borrowing individuals fail to repay their debt optimally? We design a diagnostic laboratory experiment where we rule out selection into debt and other confounds present in the field as potential explanations. We document that allocations are predominantly suboptimal even when individuals are attentive to interest rates, equipped with optimization ability, and face unrealistically high interest rate differences. We use revealed preference methods and identify mental accounting as a crucial mechanism through a novel parametric test of fungibility. We further investigate if optimization failures extend to an algebraically identical investment problem. Our structural estimates reveal debt frame substantially increases fungibility violations compared to an algebraically identical investment frame. Choice process data document the debt frame increases subjects’ focus on the irrelevant balance information. These results have implications on boundedly rational models of decision-making, the design of consumer protection policies, and the evolution of wealth inequality.

Presented at American Finance Association (Poster Session) 2023*, Financial Management Association 2022*, Saint Louis University 2022*, Toulouse School of Economics (2021), Society for Experimental Finance 2021, Bilkent University (2021), METU (2021), Maastricht Behavioral and Experimental Economics Symposium (M-BEES) 2021, NeuroPsychoEconomics Conference 2021, Western Economic Association International (WEAI) 2021, Southwest Experimental and Behavioral Economics Workshop (SWEBE) 2019, Washington University St. Louis EGSC 2019, Economic Science Association (ESA) North America 2019*, UCSB Behavioral Econ Workshop (2019)

Abstract: This paper experimentally studies how people learn about their environment when their subjective understanding of the environment, their mental model, is misspecified. We use people's tendency to hold optimistic beliefs about their abilities to generate a significant amount of model misspecification and investigate the implications of overconfidence as a misspecified mental model on learning about own ability and a fundamental. Consistent with theoretical predictions, overconfident subjects develop pessimistic beliefs about the fundamental and take growingly suboptimal actions. Inconsistent with the theoretical prediction, endogenous feedback does not exacerbate the extent of suboptimal behavior. Investigating how subjects learn about their own ability reveals that abundant feedback "weakens" misspecified mental models. The "weakening" of mental models is more pronounced with endogenous feedback and explains why endogenous feedback may not exacerbate the extent of suboptimal behavior.

Presented at Early Career Behavioral Economics Conference at Harvard 2023, European Economic Association-Econometric Society Meeting Barcelona 2023, Economic Science Association Lyon 2023, Institute for Advanced Studies Toulouse 2023, University of Amsterdam CREED 2023, M-BEES Maastricht 2023, ASFEE Montpellier 2023, ESA Santa Barbara 2022, UCSB Behavioral Econ Workshop (2020)

Abstract: Borrowers with revolving debt on multiple accounts often fail to exploit price differences when making their repayments and leave a considerable amount of money on the table. Constructing a simple repayment environment in the laboratory, we test the role of behavioral mechanisms that would directly inform the design of consumer protection policies. We find that anchoring on the irrelevant balance information does not contribute to the choice inefficiencies. Instead, participants with low financial literacy struggle to process interest rate information in percentage format as a price and improve their choices when interest rates are presented in a fee format. Providing an opportunity to purchase financial advice reveals that most participants are somewhat aware of their choice inefficiencies, but the majority of participants underestimate the extent of their mistakes, under-demand, and under-utilize financial advice. Our results underscore the critical role of financial literacy, as it not only directly influences the effectiveness of potential disclosure policies but also shapes individuals’ awareness of their mistakes.

Presented at   Boulder Summer Conference in Consumer Financial Decision Making 2024 (scheduled)*, 12th FDIC Consumer Research Symposium Poster Session 2024*, NTA 2023*, International Institute of Public Finance 2023*, Society for Experimental Finance 2022, ESA North America 2022*

*presentation by the coauthor