Optimal Cost Function When Cost of Misclassification is Higher for the Customer than for the Business

15 Apr

Consider a bank making decisions about loans. For the bank, making lending decisions optimally means reducing prediction errors*(cost of errors) minus the cost of making predictions (Keeping things simple here). The cost of any one particular error — especially, denial of loan when eligible– is typically small for the bank, but very consequential for the applicant. So the applicant may be willing to pay the bank money to increase the accuracy of their decisions. Say, willing to compensate the bank for the cost of getting a person to take a closer look at the file. If customers are willing to pay the cost, accuracy rates can increase without reducing profits. (Under some circumstances, a bank may well be able to increase profits.) Customer’s willingness to pay for increasing accuracy is typically not exploited by the lending institutions. It may be well worth exploring it.