In today’s digital age, credit cards have become indispensable tools for consumers worldwide. With a simple swipe or tap, we can access a world of convenience and rewards. Banks meticulously craft credit card rewards, advertising them as unique selling propositions for their credit card products. Indeed, these reward programs are commonly seen as a prominent feature of credit cards. It was reported that the reward payment reached 67.9 billion US dollars in 2022 and was rising among the top six credit card issuers in the United States.
Credit card rewards cover a wide range of consumption categories. Apart from high-end services like flight tickets, hotels, and tourist attractions, rewards can also be used for daily purchases such as groceries and restaurants.
However, behind the allure of cashback, points, and travel perks lies a complex web of incentives and behaviors that can have profound implications for our financial behavior. Do these reward programs change our purchase behavior? While we may end up spending more in order to utilize reward benefits, will the redeemed rewards pay off the increased spending? More importantly, do consumers realize these changes in spending habits? My recent paper attempts to answer these questions.
Data from A Major Commercial Bank in China
We collaborated with a major commercial bank and analyzed consumers’ spending and reward usage behavior. To understand consumers’ subjective expectations of spending, we deployed a survey to elicit their perceptions. Tailored questions prompted consumers to estimate their total spending and the portion that would yield credit card rewards. We then integrated these perceptions with proprietary monthly administrative data detailing each consumer’s financial decisions, including spending (through both checking and credit accounts), savings, and reward redemption behavior. This dataset, which juxtaposes consumer beliefs and revealed preferences, provides an ideal lab to study consumption patterns and consumer beliefs within the credit card market.
Our analysis hinged on the distinct reward designs offered to consumers. On the bank’s product line of credit cards, a Gold card offers a certain set of benefits, while a Platinum card tantalizes with additional perks exclusive to its tier. Using these data, we focused on the effect of Platinum card rewards on spending habits.
The Quest for Causality: How Credit Card Rewards Influence Consumer Behavior
But how do we evaluate how those enticing offers and perks offered by the Platinum cards influence purchasing decisions? A simple linear regression of spending on rewards would not work, as these two variables almost certainly have a positive correlation: a consumer may opt for increased consumption due to their intent to redeem high-value rewards. As a result, such “reward chasers” and “non-chasers” may not yield an apples-to-apples comparison. Randomizing card products among consumers can also be impractical, as it may not be incentive-compatible for banks to have an unstable product image.
With randomization out of reach, we turned to observational data, embracing its nuances and limitations. The Platinum card, being on the higher end than the Gold card, has a stricter eligibility criterion: it mandates that consumers can only receive a Platinum card if their total assets with the bank exceed some threshold. While the decision to opt for a Gold or Platinum card may not be random, a consumer’s total assets lying just below and above the Platinum eligibility threshold can be deemed as just a matter of chance. By surpassing the asset threshold, consumers unlock the gateway to Platinum rewards, so we can tease out the causal effect of Platinum rewards on consumer behavior by comparing the behaviors of Platinum users whose assets are just above the threshold and those of Gold users whose assets are just below the threshold. This cutting-edge causal inference technique is called a regression discontinuity design.
The Allure and Pitfalls of Credit Card Rewards
Imagine this scenario: you’re planning a vacation, and you stumble upon a tantalizing offer for a flight rewards credit card. The promise of earning points with every purchase fills you with excitement, and you eagerly purchase flight tickets and go on travels, envisioning free flights for future holiday seasons. It’s a seductive proposition—one that millions of consumers around the world succumb to every year. This will result in spending increases not only in the category of flight tickets, but also in other travel-related expenses, such as accommodations, dining, and transportation.
While the promise of earning points for travel purchases may be enticing, consumers may overlook the fact that they will also need to spend money on those add-on travel-related expenses, which are considered complementary to flight tickets. We define this oversight as complementarity ignorance—a failure to consider the full spectrum of complementary purchases that may arise from a single spending decision.
Now that we have unveiled the concept of complementarity ignorance, let’s explore its hidden costs. When consumers focus solely on earning rewards in one category of spending, they may overspend in that category while neglecting other essential expenses. This can lead to a cycle of debt and financial instability, as consumers struggle to balance their spending priorities.
Furthermore, complementarity ignorance can distort market dynamics. Apart from debts, banks earn revenue from interchange fees at a negotiated rate through each card transaction. Since complementarity ignorance will lead to larger expenditures by consumers as they enjoy the perks, it can incentivize credit card issuers to offer increasingly generous rewards in order to further exploit consumers’ inattention to their spending. This can largely explain why credit card rewards usually include consumption with a large variety of complementary purchases, such as grocery shopping and travel, but do not cover essential services such as utility bills.
Final Remarks
So how can consumers and policymakers address the challenges of complementarity ignorance? One approach is to increase transparency and consumer education around credit card rewards. By providing clear and accessible information about reward programs, consumers can make more informed decisions about their spending habits.
Policymakers can also play a role in regulating the credit card industry and protecting consumers from predatory practices. By implementing rules and regulations that promote transparency, fairness, and consumer welfare, policymakers can help mitigate the negative effects of complementarity ignorance and create a more level playing field for all participants.
As we look to the future of credit card markets, it’s clear that complementarity ignorance will continue to shape consumer behavior and market dynamics. However, by raising awareness of the hidden costs of complementarity ignorance and advocating for policies that promote transparency and consumer welfare, we can work towards a more sustainable and equitable credit card market for all.
In conclusion, credit card rewards offer a tantalizing array of benefits, but they also come with hidden costs that can have profound implications for consumer welfare and market dynamics. By understanding the complexities of reward behavior and complementarity ignorance, we can empower consumers to make more informed decisions and create a more equitable and transparent credit card market for the future.
Tianyu Han is an Assistant Professor of Marketing at the School of Business and Management, Hong Kong University of Science and Technology. This post was adapted from his paper, “Rewards and Consumption in the Credit Card Market,” available on SSRN.