Economics Letters 139 (2016) 84–87

Contents lists available at ScienceDirect

Economics Letters
journal homepage: www.elsevier.com/locate/ecolet

Bank overdraft pricing and myopic consumers

Marlon L. Williams ∗
Department of Economics and Finance, University of Dayton, 300 College Park, Dayton, OH 45469, United States

highlights
• There has been a dramatic increase in the use of bank overdrafts in the last decade.
• I examine the link between bank overdraft prices and consumer myopia.
• Myopia is higher in young, rich populations with a higher proportion of females.
• The findings suggest that banks target myopic consumers with expensive overdrafts.

article info abstract

Article history: In recent years, banks have routinely earned annual percentage rates of over 1,000 percent on overdraft
Received 21 July 2015 services. Such returns are staggeringly high, especially in an arguably competitive industry; and
Received in revised form consequently, consumer protection groups have been lobbying for increased oversight of bank overdraft
18 December 2015
fees (and similar fees). In the context of a model proposed by Gabaix and Laibson 2006, I find support for
Accepted 28 December 2015
Available online 6 January 2016
the argument that banks target myopic consumers — consumers who do not consider the add-on good
when choosing the base product. Using demographic characteristics to proxy for the proportion of myopic
JEL classification:
consumers, I find results that are consistent with Gabaix and Laibson 2006 in the pricing of bank overdraft
D4 services.
L1 © 2016 Elsevier B.V. All rights reserved.
L8

Keywords:
Banks
Overdraft
Myopic consumers
Bank pricing
Add-on pricing

1. Introduction industries where firms shroud information about add-on goods

Over the last decade we have witnessed a dramatic increase in
the availability and use of overdraft services. A 2008 FDIC Study
of Bank Overdraft Programs reports that 76.9% of large banks had
an automated overdraft program. Banks suggest that overdraft ser-
vice has been extended as a courtesy to consumers, who would
otherwise be adversely affected by declined transactions. How-
ever, many consumers and consumer protection groups argue that
banks are using ‘‘courtesy’’ overdrafts merely to increase fee in-
come at the expense of, especially, young, low-income households.
Authors, such as Fusaro (2010), use consumer-level data to
show that the majority of overdrafts result from consumers’
mistakes. However, limited theoretical work has tackled the
problem of bank overdrafts directly. Gabaix and Laibson (2006)
(hereafter, G&L) propose a model that explains the existence of
∗ Tel.: +1 937 229 3618.
E-mail address: mwilliams7@udayton.edu.
http://dx.doi.org/10.1016/j.econlet.2015.12.022
0165-1765/© 2016 Elsevier B.V. All rights reserved.
and price them above marginal cost. In their model, banks are able
to do so if a sufficiently large fraction of consumers are myopic —
myopic in the sense that they do not consider these add-on goods
when choosing the base product.
Using six years of repeated cross-sectional data on overdraft
fees, I attempt to determine if the presence of myopic consumers
is a significant factor in the pricing of overdraft fees by U.S. banks
and credit unions. Using age, income, education, and gender to
proxy for the fraction of myopic consumers, I find that age, income,
gender, and (interestingly) the presence of substitute overdraft
protection options significantly influence overdraft fees in the
direction predicted by G&L.
2. A model of add-on pricing: Gabaix and Laibson (2006)
Gabaix and Laibson (2006) put forward a reasonably compelling
explanation for why firms would choose to shroud relevant
product information even in competitive markets where the cost of
disseminating such information is negligible. The key assumption
 M.L. Williams / Economics Letters 139 (2016) 84–87 85

of G&L is that a strictly positive fraction of consumers are ‘‘myopic’’ Table 1

as opposed to being ‘‘sophisticated’’. Myopic consumers are those Summary statistics.

that do not consider the cost of shrouded add-on products when
purchasing the base good. I apply a slightly modified version of
G&L’s model to the market for overdraft service, the add-on good,
with the base good being checking accounts. I give a very brief
description of the most salient features of this version of the model
below.
Potentially differentiated firms make three decisions: (1)
Whether or not to shroud overdraft services, (2) The price of check-
ing account services, and (3) The price of overdraft services. Each
consumer makes two decisions: (1) Which firm to open a checking
account with and (2) How much costly effort to exert in an attempt
to avoid using overdraft services. Sophisticated consumers opti-
mally choose their effort levels, whereas the myopic consumers
passively choose some default effort level, given that they do not
consider overdraft services at the time of purchasing the checking
account.
G&L show under relatively weak conditions that a unique
symmetric shrouded price equilibrium exists, with firms charging
ˆ (p̂) and
p = µ − (p̂ − ĉ )pr
p̂ = p̂m
for the base good and the add-on good, respectively. µ is a constant,
ĉ is the firm’s marginal production cost of overdraft service, p̂m is
ˆ (p̂) ≡ (1 −α)prS (p̂)+α prM
the firm’s monopoly overdraft price, pr
is the average probability of consumers overdrafting, and α is the
proportion of myopic consumers.
3. The regression model
Given reasonable functional forms for the probability of
overdrafting and cost of effort functions, G&L provide a number of
empirically testable predictions. The one that is most relevant for
our application is that the absolute difference between the price of
the add-on and the price of the base good should be larger in markets
with a larger fraction of myopic consumers. The goal of my empirical
model is to explain the variation in overdraft fees across banks
and credit unions with a combination of variables that measure
the proportion of inexperience or uninformed consumers. I also
control for observable characteristics of banks and credit unions
that measure heterogeneity in product quality and cost.
I estimate the following regression equation using OLS:
Yimt = α0 + β Ximt + ζ Zm + δ Dt + ηMmt + ϵimt ,
where Yimt is the real overdraft fee charged by firm i in city m in year
t. Ximt is a vector of firm-specific characteristics that are allowed to
vary over time and across cities. These include firm type (bank or
credit union), firm size, and the availability of overdraft protection
options. I assume that firms choose the price of overdraft after
having decided on what overdraft protection options to offer and
also after having determined the price of a checking account.
Zm is a vector of time-invariant demographic variables, which
are used to proxy for the fraction of myopic consumers in each
market. Dt is a vector of year dummies. Mmt is a vector of market-
specific variables, which include the Herfindahl–Hirschman Index
(HHI), city size, and state dummies. ϵimt is the error term, which
is assumed to be i.i.d. across markets, years, and firms, and
has mean zero. The vectors of parameters to be estimated are
α0 , β, ζ , δ, and η.1
1 I use OLS because the data set is a repeated cross section, rather than a true
(unbalanced) panel. However, I confirm that the qualitative results are valid by
transforming the repeated cross section to a pseudo panel, and then estimating the
coefficients using a random effects model. This transformation is done by creating
cohorts as proposed by Deaton (1985).
Variable Mean Median Min Max Std. Dev.
Overdraft fee ($) 25.98 26.60 1.03 45.43 5.75
Median Age 35.26 35.00 20.70 68.80 4.60
Median Income ($’000) 55.68 51.30 16.44 282.92 19.92
Education* 0.805 0.812 0.240 0.985 0.091
Female proportion** 0.529 0.530 0.098 0.633 0.026
*
Fraction of the population, 25 years and older, that has at least a high school
diploma or its equivalent.
**
Fraction of the population, 25 years and older, that are females.
An additional underlying assumption is that banks choose the
prices of their products to maximize their profits in a given market
(city), conditional on the market conditions of each individual
market. This hypothesis is validated to some extent in the data set,
given that for the few banks that I have observations in multiple
cities in the same year (even in the same state), I do observe
significant price differences. Under this optimization assumption, I
define the unit of observation as a bank in a given market in a given
time period; and consequently I can link even multi-market banks
with individual market-specific proxies.
(1)
4. Data description
I utilize bank and credit union data on overdraft fees from a
repeated cross-sectional survey of branches conducted by Moebs
$ervices Inc. Each cross section is obtained by using a stratified
sampling procedure to reflect the population in terms of firm size
and regions of the country. The data set covers the 2004–2009
period and provides 7,903 total observations on 5,206 unique
city–bank pairs.
I augment Moebs’ data set with demographic data from the
2000 Decennial Census conducted by the U.S. Census Bureau. I
utilize four demographic characteristics: median age; median in-
come; the fraction of the population, twenty-five and older that
has a high school diploma or its equivalent; and the fraction of the
population that is female. These choices are based on the expecta-
tion that they strongly correlate with the fraction of myopic con-
sumers in a geographic market. Table 1 presents summary statis-
tics on overdraft fees along with the four demographic variables.
The Herfindahl–Hirschman Index (HHI) is used to control for
differences in the level of competition across cities. The HHI is
calculated for each city–year pair using FDIC data on the deposits
of bank branches.
(2)
5. Results
Table 2 reports the results of regression equation (2). I am
mostly interested in the variables that allow me to speak to the
importance of the presence of myopic consumers in the market
for overdraft services. Though space does not allow me to dis-
cuss the other variables, all significant variables had the expected
sign: Banks charge more than credit unions; larger (smaller) banks
charge higher (lower) prices in more concentrated market; and
banks that offer free checking accounts charge higher overdraft
prices.
In interpreting the effects of the demographic variables, it is im-
portant to bear in mind that there can be two possible sources of
myopia: (1) The consumer can be ignorant about overdraft services
or (2) The consumer can choose to ignore overdraft services based
on his/her expectation that he/she will not use it in the future. Any
factor that increases a consumer’s financial literacy level or finan-
cial attentiveness is likely to lower the probability that that con-
sumer will be myopic. See Bumcrot et al. (2011), Fusaro (2008), and
DellaVigna and Malmendier (2006) for evidence of direct and indi-
rect links between the chosen demographic variables and financial
literacy or financial attentiveness.
86 M.L. Williams / Economics Letters 139 (2016) 84–87

Table 2
Results of OLS regression.
Dependent variable: Overdraft fee
Regressor Robust
Coefficient Standard error P-value

Demographic variables
Median Age −0.082 0.014 0.000
Median Income (natural log) 1.850 0.282 0.000
Education −1.176 0.903 0.193
Female proportion 11.070 3.046 0.000
Firm-specific controls
Bank dummy 3.539 0.214 0.000
Small firm dummy −0.653 0.198 0.001
Large firm dummy 0.569 0.335 0.089
Free checking dummy 0.729 0.126 0.000
Alternatives to overdraft services
Linked account only dummy 0.505 0.320 0.115
Line of credit only dummy 2.017 0.342 0.000
Both overdraft protection dummy 1.695 0.300 0.000
Market-specific controls
HHI 0.957 0.695 0.169
HHI x bank dummy −2.033 0.637 0.001
HHI x small firm dummy −1.845 0.492 0.000
HHI x big firm dummy 2.856 1.108 0.010

Age
We can conjecture that younger consumers are more likely to
be myopic. To some extent, we can approximate a consumer’s
financial experience by his/her age. All else equal, an older person
is more likely to have had an overdraft or non-sufficient funds
transaction in the past. Thus, an older consumer is more likely to be,
at least, aware of general overdraft policies of banks than a younger
consumer. Given that G&L predicts that the equilibrium price of the
add-on will be higher in markets with a higher fraction of myopic
consumers, we expect higher prices for overdraft services in cities
with a younger population. Finding the effect of age to be negative
and significant at the 1% level is thus consistent with G&L, and hints
at the idea that banks are targeting myopic consumers.
Income
The higher a consumer’s income the less likely that consumer
will need overdraft services, and consequently, the less likely
he/she will consider overdraft services when deciding on a bank.
Thus, we expect to have a higher fraction of myopic consumers in
high-income cities. I find that income is positive and significant at
the 1% level. This result is again consistent with G&L.2
Education
The a priori expectation is that increased education can have
two conflicting effects on the level of myopia: (1) A more educated
population is likely to have a higher level of financial literacy, and
therefore have a lower fraction of myopic individuals. (2) However,
it is also reasonable to expect that high-educated individuals
are more likely to (perhaps deliberately) disregard overdraft fee
because of their belief that the probability that they will use
overdraft services is sufficiently low.
Education is not significant at any reasonable level of signifi-
cance. This likely results from the fact that income and education
are strongly positively correlated. Taken together, the income and
education coefficients suggest that banks charge higher overdraft
fees in areas that have a richer, more-educated population. This is
perfectly consistent with G&L’s model — a richer, more-educated
population that does not expect to use overdraft services suffi-
ciently much, would choose to ignore the price of overdrafting at
the time of opening a checking account.
2 Another channel through which income could affect the price of overdraft
services is that high-income consumers, sophisticated or myopic, are likely to be
less price-sensitive.
Gender
There is no a priori reason to expect that females are more likely
to be myopic than males. However, I include it as proxy because
previous studies, such as Bumcrot et al. (2011) found ‘‘lower
financial literacy levels among women, those with low education,
and African–Americans and Hispanics’’. Here, I find the coefficient
on the proportion of female to be positive and significant at the
1% level, again consistent with G&L. I do not include a variable for
race due to the lack of availability at the city level in my current
data set. Race is likely to be strongly correlated with income, and
its omission would bias the income coefficient downwards, which
strengthened the finding on income.
Availability of overdraft protection options
The cost to consumers for each overdraft is significantly reduced
if the consumer opts for an overdraft protection option before
the incidence of the overdraft. The two main overdraft protection
options are linked accounts and line of credit. Dummies are
included in the regression to control for the availability of linked
accounts only, line of credit only, or both. The dummies on line of
credit only and both options are significant at the 1% level, whereas
the dummy for linked accounts only is insignificant.
The positive coefficients are consistent with G&L in the
following way: G&L’s main thesis is that sophisticated consumers
consider the add-on good (overdraft service) when choosing the
base good (checking account), whereas myopic consumers do
not. As such, only the behavior of sophisticated consumers is
affected by the availability of overdraft protection options. For
a given fraction of myopic consumers, firms attempt to exploit
myopic consumers without losing significant market share of
sophisticated consumers. When sophisticated consumers have a
cheaper substitute to overdrafting, it allows firms to charge a
higher overdraft fee without severely sacrificing its sophisticated-
consumer base. I find that, on average, a bank that offers line of
credit has an overdraft fee that is $2.02 higher than a bank that
offers no overdraft protection option.
This finding appears to provide substantial support for G&L’s
thesis. This is so given that overdraft protection options can be con-
sidered as substitutes for overdraft services. Standard theory as-
serts that the price of overdrafts should be lower in the presence
of cheap, easily-accessible substitutes. The existence of a strict di-
chotomy of consumers — myopic versus sophisticated — appears to
be a very plausible reason for us observing the opposite effect here.
 M.L. Williams / Economics Letters 139 (2016) 84–87
6. Concluding remarks
This paper tests the implications of the model proposed by
Gabaix and Laibson (2006), which seeks to explain the existence of
information suppression and above-marginal pricing of add-ons in
seemingly competitive markets. The authors make a non-trivial as-
sumption that consumers are either myopic or sophisticated. My-
opic consumers are those who ignore the possibility of subsequent
demand for the add-on when purchasing the base good.
Here, I empirically test the importance of the presence of my-
opic consumers in the pricing of overdraft services using a repeated
cross section of U.S. banks and credit unions. Using demographic
proxies for the fraction of myopic consumers, I find that the re-
lationships between overdraft fees and the proxies are consistent
with the theoretical model. However, the strongest support for
Gabaix and Laibson (2006) may be the result that banks that of-
fer consumers a cheaper alternative to overdraft services, charge
higher overdraft fees. The overall findings suggest that banks may
indeed be targeting myopic consumers with extremely expensive
overdraft services, and therefore a structural estimation of Gabaix
and Laibson’s model is likely to provide very useful insights to help
us better understand the pricing of add-ons and after-sale services.
87
Acknowledgments
I am grateful for the faculty, staff, and fellow past graduate
students of the Economics Department at the Pennsylvania State
University for their support of this research and my dissertation
work overall. I am especially thankful for my thesis co-advisers,
Prof. Mark J. Roberts and Prof. Edward Green, who provided
invaluable guidance. I also extend much appreciation to Moebs
$ervices Inc. for providing the necessary data. I am also very
grateful for an anonymous referee, who provided significant
feedback that helped to improve this paper.
References
Bumcrot, C., Lin, J., Lusardi, A., 2011. The geography of financial literacy, Financial
Literacy Center Working Paper, WR-893-SSA.
Deaton, A., 1985. Panel data from time series of cross-sections. J. Econometrics 30,
109–126.
DellaVigna, S., Malmendier, U., 2006. Paying not to go to the gym. Am. Econ. Rev.
96 (3), 694–719.
Fusaro, M., 2008. Hidden consumer loans: An analysis of implicit interest rates on
bounce checks. J. Fam. Econ. Issues 29 (2), 251–263.
Fusaro, M., 2010. Are bounced check loans really loans? Q. Rev. Econ. Financ. 50 (4),
492–500.
Gabaix, X., Laibson, D., 2006. Shrouded attributes, consumer myopia, and
information suppression. Q. J. Econ. 121 (2), 505–540.