Explore BrainMass

Special Pricing Practices: Credit Card and Interest Rates

Because credit card companies and banks must charge the same interest rate on credit cards to all borrowers, there is an adverse selection problem with credit cards. How does a credit card company or firm know whether a person will be a high-quality borrower (i.e., one who pays the debts) or a lower-quality borrower (i.e., one who does not pay debts)?

a. How the restrictions of a single rate leads to an adverse selection problem, and
b. At least two potential means that credit card companies can use to try to lessen this problem.

Solution Preview

Part A
People who are high-quality borrowers will pay down their debt and maintain a lower credit card balance thus paying less in interest. The credit card company actually wants these people to borrow more (since it is safe to lend them money) but the opposite happens.
People who are low-quality borrowers will not pay down their debt and maintain a higher (riskier) credit card balance thus paying more ...