On the other hand, proponents of free markets would view such directives as unnecessary state interference. According to them the current rates charged must be the ‘equilibrium’ rates that compensate for credit risk of banks, and competition among banks should eliminate any excessive profiteering. Attempts to impose lower interest rates will only disturb this equilibrium resulting in severe adverse consequences.
Allure of free markets
The idea of free markets is very alluring as they predict the optimal outcome without the need for any external interference. According to this idea, as long as competitive markets operate free from regulatory interference, competition should lead to the equilibrium where firms only make normal profits to justify their survival and customers end up getting the best deal. Attempts to regulate will only disturb this blissful harmony and will leave consumers worse off due to weakening of competitive forces.
Are Credit Card markets free?
Notwithstanding the academic elegance of the above argument, research continues to show that credit card markets do not seem to fit in to this model. For example, inspite of being extremely competitive, credit card companies in the USA have managed to charge excessive interest rates over the years and introduced various types of hidden fees and penalties. Moreover, interest rates of credit cards tend not to go down even when cost of capital for banks goes down significantly. Not surprisingly, credit card business continues to be one of the most profitable segments of US banks. Such behavior seems a paradox under classic economic theory, given the high level of competition and lack of evidence on any collusion among banks (In economics, the term ‘collusion’ refers to instances where some parties (e.g. firms) get together into unlawful agreements where other parties (e.g. consumers) will be unfairly exploited).
What does research say?
A considerable amount of research has been carried out to shed light on why credit card markets do not follow the free market theory. Some possible explanations have emerged. One potential reason why banks seem to be able to charge excessive rates is that at the time of applying for a card, the typical consumer expects he would be able to pay all outstanding balances within the grace period where no interest is charged and therefore do not pay much attention to the interest rate.
Moreover, it is argued that search costs (costs involved with looking for the best deal) and switching costs (costs involved with moving out of current card and getting a new one) faced by the consumer prevents the functioning of perfect competition.
Additionally emerging research in economics suggests that ‘equilibrium’ behavior proposed by classic economic theorists and proponents of free markets is considerably flawed. For example, research in the game theory shows that at times, monopoly like behavior can emerge even in markets with many competing firms without any explicit collusion among them (In other words, a sort of an “implicit collusion” can emerge as an alternative equilibrium).
If banks can end up abusing credit card users in developed and highly competitive markets such as the USA, the concerns would be only greater in a country such as Sri Lanka where the level of competition is much lower.
