The Debt Payment Puzzle: An Experimental Investigation
95 Pages Posted: 6 Aug 2019 Last revised: 25 Oct 2023
Date Written: October 23, 2023
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 the main 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.
JEL Classification: C91, D14, D18, D91
Suggested Citation: Suggested Citation