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Adverse selection of credit card customers

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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)?

Describe

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

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Solution Preview

Adverse selection occurs when loan offers respondents are those most likely to default on the loan. Adverse selection usually arises from an information asymmetry; in this case credit card issuers have imperfect knowledge of borrowers' circumstances and thus the market for credit doesn't reflect true risk each borrower represents.

a. Higher rates result in increased adverse selection because riskier customers ...

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