Why wouldn't competition prevent "usurious" payday loan rates?

Question

The current Wiki page on "Payday Loans" claims loans are priced above marginal cost. The justification is that

If a lender chooses to innovate and reduce cost to borrowers in order to secure a larger share of the market, the competing lenders will instantly do the same, negating the effect. For this reason, among others, all lenders in the payday marketplace charge at or very near the maximum fees and rates allowed by local law. [23]

Doesn't this logic contradict the fact that competitive markets price goods at their marginal cost?

Is there an implicit assumption that the payday loan market is not sufficiently competitive? If so, is this assumption true?

Answer 1

The posted quote is economic nonsense.

If a lender chooses to innovate and reduce cost to borrowers in order to secure a larger share of the market, the competing lenders will instantly do the same, negating the effect.

This applies to any industry without intellectual property protection -- it is hardly unique to the payday loan industry. By this logic, we'd expect to encounter massive price gouging across dozens of industries.

Besides, if payday loan innovation is in the form of software that better predicts default (the most likely path), it will be protected under copyright law and potentially software patents. And while business model innovations are not patentable, there's still a first mover advantage.

The payday loan business is not highly profitable.

Profit margins of payday-loan corporations are publicly available, and lower than most other industries. One study found that "despite the common belief, payday lending firms do not always make extraordinary profits. In fact, when compared to many other well-known lending institutions, payday lenders may fall far short in terms of profitability."

This is not surprsing, since the payday loan market is highly saturated, which suggests substantial competition.

"Usurious" APR rates are misleading.

A typical payday loan charges \$17 for a two-week \$100 loan. Expressed as an annualized rate, this is an "outrageous" 390% APR. But the loan's short-term nature means transaction costs will likely prevent a large profit. (The source of this information is potentially biased. Be sure to read critically.)

Answer 2

The Coase Theorem:

As long as private property rights are well defined under zero transaction cost, exchange will eliminate divergence and lead to efficient use of resources or highest valued use of resources.

In this case, we have clear property rights and since payday loans do exist, we can assume transaction costs are sufficiently low. So we can expect efficient use of resources. Only people who value having cash in the pocket right now higher than their promised income when they get their pay will take the loan.

The reason for this is that people often have liquidity issues. People without access to credit cards or other form of collateral may be higher risk of default. Loaners can charge a high price to compensate them from this risk whilst loanees are willing to pay that price because they can't do any better.

A more detailed analysis would also consider the predatory nature, a debt trap and also how tricky understanding a short term loan can be for a desperate low income earner. That said, I don't think any of those factors would impact the Coase theorem.

None of the Coase theorem conditions are violated here.

This source provides a lot of worthwhile discussion.

From page 2:

people borrow from payday lenders because they believe that:

• this is the best way to meet an immediate need for a cash advance of \$100 to \$500.
• Many payday loan customers apparently do not have access to lower cost credit from banks or credit unions because they have already reached the limit of the credit available from these sources.
• They have “maxed out” their credit cards and other lines of credit.
• Others do not have access to lower cost credit because they have severely impaired credit histories.
• They do not want to ask family members or friends for a cash advance because they might be judged harshly for doing so, or because they have exhausted their access to such informal alternatives.

Why doesn't this contradict the fact that competitive markets price goods at their marginal cost?

Two points here:

• A market does not need to be competitive to exist. Barriers to entry may include high regulation, ethical concerns, risk.
• If the market is in fact competitive, high profitability could be a result of a much higher exposure to risk than usual.

Note - I answered this question before some of the edits and as a result, my answer doesn't quite fit the question.

Answer 3

Keep in mind that the Coase Theorem assumes there are low transaction costs to borrowing. Someone who has a very low credit score because of high variance in their ability to pay may not have access to typically better interest rates, so there may be a high cost to negotiating/earning a better rate, especially if you are pressed for cash.

Most people who borrow money are poor, and usually in poor communities, the poor form kinship ties with other poor people. In these circles, there is high pressure to share any additional money you may get, which may discourage getting extra income unless the individual in the group is very hard pressed. So having to share wealth could arguably be a transaction cost of borrowing any loan.

If a bank knows there are high search/transaction costs for these types of consumers for finding and getting a loan, they could conceivably charge above a perfect market equilibrium I think.