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We quantitatively analyze consumer credit markets with behavioral consumers
and default. Our model incorporates over-optimistic and rational borrower types
into a standard incomplete markets with consumer bankruptcy framework. Lenders
price credit endogenously, forming beliefs – type scores – about borrowers' types.
Since over-optimistic borrowers incorrectly believe they have rational beliefs, lenders
do not need to take strategic behavior into account when updating type scores. We
find that the partial pooling of over-optimistic with rational borrowers results in
spill-overs across types via interest rates, with over-optimists being cross-subsidized
by rational consumers who have lower default rates. Higher interest rates lower the
average debt level of realists compared to a world without over-optimists. Due to
overestimating their ability to repay, over-optimists borrow too much. We evaluate
three policies to address these frictions: reducing the cost of default, educating overoptimists
about their true type, and increasing borrowing cost. Of the three, only
the lower default costs improve the welfare of over-optimists. However, rational
consumers are made worse off by that policy.
