Throughout our nation, an array of competitive, non-banking, businesses exist, producing and marketing an assortment of goods and services. These goods are sold on credit.
By studying the behavior of these firms, all acting in their best interests, it is shown how free-market, competitive capitalism leads these firms to benefit financially weak, low-income participants at the expense of financially stronger, wealthier ones. In other words, even if capitalists serve only their best interests, and are not altruists, their profit-maximizing behavior can lead to altruistic outcomes.
“Unbelievable,” you say.
To get started, note that the typical firm’s credit manager can view her operating costs as consisting of two categories: product costs and credit costs. Product costs are outlays for supplies and labor. Credit costs are bad-debt losses plus the cost of customer delinquency that precedes the bad-debt write-off. The latter cost is not an outlay of cash. It is an opportunity cost, expressed in the credit manager’s terms. Warning: Just because this cost is non-cash does not mean it is less real than cash costs. (If some of the following sounds a little too pedantic, I apologize. Bear with me.)
The outstanding aspect of these credit costs is that they vary with the individual customer’s characteristics. This creates nightmares for the manager. Based on FICO, or other appropriate scores, and a host of additional information, much of which is accessible from the customer, the manager knows that customers are distributed among risk classes. Those who are more likely to incur bad-debt or delinquency costs are in higher risk classes. Moreover, mountains of evidence have shown that the higher the risk class of a customer, the higher are the customer’s credit costs, a relationship that is almost a law of credit analysis.
To earn as much money as possible it makes sense for the firm to attempt to factor into its prices expected bad-debt losses and expected delinquency costs, a risk premium as the economist might put it. Competition tends to force many competitors to implant this premium for bad-debt loss into their product prices, but less likely to duplicate this act with delinquency costs. Intuitively they are more concerned about recovering bad-debt losses, which are closer to them than non-cash, non-tangible delinquency costs.
The strength of this motive is a matter of degree. In many cases, the overall net result is that bad-debt loss tends to be reflected in competitive prices to a greater degree than delinquency costs. An important reason for this result is that the cost of collecting delinquency costs must be considered, which weighs against pursuing such customers.
Consider now the following scenario: Imagine that the credit-granting firm can generate its operational experiences, hypothetically, over and over again. This yields a sample for which it calculates the average of these credit outcomes: defaults, delinquent balances and so forth. By having some or all of the seller’s uncollectible debt written off, and virtually nothing reimbursed for delinquency costs, on average, many high credit-risk customers become freed from these credit burdens, albeit delinquency cost is more of a moral, rather than a legal obligation.
Profit-maximizing firms tend to capture these expected costs in their prices, so low credit-risk customers are, on average, bearing the burden of these costs. Why? In this milieu delinquent customers, on average, avoid paying such costs because they tend not to be charged for them. This does not prevent some firms from placing restrictions on credit to borrowers who are prone to delinquency.
These surprising average outcomes are reached despite the fact the firm is not acting altruistically, but instead is serving its self-interest. Another surprising result: since its financially weak, high credit-risk customers are correlated with low-income participants, low-income customers tend to be subsidized by the firm’s low-risk customers.
The media, joined by Marxists, socialists, Leninists and progressives lead us to believe capitalism is bad, if not evil, because entrepreneurs are greedy, and people of low wealth are always exploited by the system. Our example contradicts this statement. We have shown that after the dust settles, it is possible there are some firms where defaulting, and/or delinquent customers, are not paying their incurred credit costs.
Since the competitive-profit-seeking firm by definition tries to avoid absorbing such costs, the only other possible meaningful participant who can shoulder part, or this entire, burden is its mainly unwitting low-defaulting, low-delinquent-risk customer, who we know, from correlation studies, is usually a person of some means. Further, in contrast to the widely noted transfer of government taxes to workers in, say, Communist Cuba, the transfer in our case is between low-risk and high-risk customers of a private credit-supplying firm, i.e., between private parties.
Therefore, in a regime where entrepreneurs act strictly in their self-interests, free-market, competitive capitalism can produce an altruistic, welfare effect. This result goes beyond Adam Smith’s famous “invisible hand,” which provides in part that in a free-exchange economy, with everybody acting in their self-interest, exchanges of goods and services are of mutual benefit to participants.
Our conclusion, however, provides that outcomes will be of mutual benefit subject to the possible welfare, altruistic effects conferred onto the poor in credit transactions by people of means, which ironically is a major Marxist objective.
Finally, a useful insight can be noted: Because entrepreneurs are not that altruistic in managing their business interests, however, does not mean they cannot be champions of altruism with respect to distributions of their personal wealth. Indeed, maximizing business wealth allows them to acquire the wealth to better satisfy personal altruistic motives of distributions of personal assets.
Space limitations do not allow the development of more implications, but the reader is invited to ponder them.
(The writer is a professor emeritus of financial economics at the University of Georgia. He lives in Aiken, S.C.)