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by Arnold Kling
March 14, 2001
...rationality is an assumption I make about other people. I know myself well enough to allow for the consequences of my own irrationality. But for the vast mass of my fellow humans, about whom I know very little, rationality is the best predictive assumption available.
--David Friedman, Hidden Order: The Economics of Everyday Life, p. 5
Suppose that there are two pools of people with 30-year fixed-rate mortgages. One pool has rates of 10 percent, and the other pool has rates of 9 percent. Today, the rate for new mortgages falls from 7.5 percent to 7 percent. Which pool is more likely to refinance?
One might reasonably suppose that more refinancers would come from the 10 percent pool, since they have a larger incentive to reduce their mortgage rate. However, in fact you are likely to observe a greater tendency to refinance among those in the 9 percent pool.
Why would there be relatively less refinancing among borrowers with higher interest rates? The answer is that these are borrowers who have passed up a chance to refinance at 7.5 percent, and therefore you can count on them to stick with their high-rate mortgages even if rates fall to 7.0 percent.
We need a label for these stubbornly irrational people. Someone else might have called them deadheads. However, Bob Van Order, the Freddie Mac chief economist who was among the first to identify this phenomenon, did not want to associate it with his favorite rock group. So mortgage borrowers who refuse to refinance out of high-rate loans are called woodheads.
Woodheads are the object of study in a sub-field known as "behavioral economics." However, the practictioners of this approach must be very dissatisfied with the term "woodhead," because as far as I can tell the entire purpose of "behavioral economics" is to come up with alternative conceptual labels, such as "prospect theory" or "loss aversion," to describe woodheads.
Does the existence of woodheads have predictable consequences? Are these consequences interesting? If not, then they are not worthy of the attention that the behavioral economists would have us pay to them.
Most of the time, woodheads go about their business of throwing away wealth without affecting the rest of us. They buy whole-life insurance policies instead of term, they pay for collision "insurance" on their cars, and they buy extended warranties on small appliances. None of that has any externalities, as far as I can see.
(Collision insurance is one of my pet peeves.
The interesting spillovers occur when companies have to subsidize rational consumers in order to take advantage of woodheads. I can only think of a few situations in which this occurs.
The woodheads carry balances and incur interest charges. The credit card companies lure them with no-fee cards, which the rest of us can use to our advantage.
As Andrew Odlyzko points out, in theory AOL should have suffered a loss by introducing flat-rate pricing. Only the online addicts should have adopted the flat rate, with the low-usage customers opting for an hourly plan. This would have forced AOL to charge more for flat-rate service in order to recover costs. This in turn would have allowed other Internet Service Providers to compete more effectively for the high-usage consumer.
However, the low-usage woodheads preferred a flat rate, even though this makes the service more expensive for them. This was particularly advantageous to AOL, which attracts a disproportionate share of woodheads.
This allows the rest of us to earn a slightly higher return at slightly less risk than would be the case otherwise. How one can take advantage of this--and not be a woodhead oneself--is the subject of another essay.
All of us are woodheads in some aspects of our economic lives. However, with the possible exception of the stock market, my tendency is to view woodhead behavior as having relatively uninteresting consequences overall.