Behavioural economics and consumption

No. 10 December 2012 Network Support Department Communications, Planning and Economic Monitoring SubDirectorate Economic and Price Monitoring Bureau Authors: Hugo Hanne 1 Behavioural economics and consumption Behavioural economics is the field of economics that studies human behaviour observed in reallife situations or under test conditions to explain individuals' economic decisions. It is popular with government agencies and regulatory authorities, especially in the US and the UK, and with companies, particularly for marketing purposes. By providing some specific examples, this paper outlines the main findings of behavioural economics as applied to consumption. 1. Overview of behavioural economics and the theory s main proponents Behavioural economics is a relatively recent discipline. One of its main proponents, Daniel Kahneman, was awarded the 2002 Nobel Prize in Economic Sciences for his pioneering work in this field. An IsraeliAmerican researcher in psychology and economics, Kahneman is known for his discovery of cognitive bias in human decisionmaking. In his paper Prospect Theory: An Analysis of Decision under Risk, he took an indepth look at stock market anomalies and decisionmaking bias. One of his brightest students, Richard Thaler, an economist at the National Bureau of Economic Research (NBER), went on to develop the nudge concept, i.e. a benevolent government measure or policy based on the principle that individuals are not as logical, selfish or rational as economic theory would have us believe. The nudge theory is based on common sense and aims to correct cognitive bias, i.e. human weakness or excessive laziness, by encouraging individuals to automatically make the best decisions for their own welfare. 1 Head of the Economic Monitoring and Pricing Unit (1B), DGCCRF 1

This economic school of thought challenges the assumptions made by the Chicago School, which argued that economic agents are rational individuals who maximise their functional utility. The School argued in favour of designing government policies based on observations of individual behaviour to encourage individuals to make decisions that would be of general economic benefit. Behavioural economic theorists suggest that individuals should receive more information and be better educated to eradicate their irrational and shortsighted behaviour when making economic decisions. Simply applying the theories of behavioural economics when implementing new government policies is not enough to protect consumers. Government bodies that take their inspiration from behavioural economics, such as the European Commission s DirectorateGeneral for Health and Consumers (SANCO), the UK s Mindspace (Institute for Government) or the US Federal Government s Office of Information and Regulatory Affairs (OIRA), carry out research in this area with the aim of designing the most economically efficient government policies, i.e. policies that will bring about a reduction in public spending (by streamlining government procedures or promoting e government policies) and that make a positive contribution to economic growth (e.g. information made available to the general public, such as food labelling, or information about the risks associated with financial products, price comparisons, etc.). UK experts have been interested in the subject since 1973 when they produced their first academic paper on the subject. Mindspace was subsequently founded in 2010 and works closely with the Prime Minister s Office. Mindspace s representative, Dr David Halpern, stated at a conference organised by the European Commission in November 2010 that the UK government was looking at ways to improve its policies dealing with obesity, addiction to smoking, alcoholism, sexually transmitted diseases and profligate uses of energy. To this end, it was collecting information about consumers behaviour and implementing public awareness campaigns or incentives aimed at encouraging UK consumers to halt these bad practices (i.e. practices that result in negative externalities and generate a cost for society as a whole). Professor Sunstein, an OIRA Director, said during the same conference that US President Barack Obama took a positive view of behavioural economics findings and wanted to implement corrective measures by, for example, making as much information as possible available to consumers on the Internet ( consumers with access to Internet are more wellinformed thanks to the comparative research carried out on products and their prices, for example ) to encourage greater transparency and more widespread regulation ( government websites may in future publish lists of companies that are misleading consumers or manipulating prices; the US Environmental Protection Agency (EPA) could display a list of polluting companies on its website, while other agencies could publish lists of criminals, risky pharmaceutical products, etc. ). In this way, egovernment, while cutting costs (fewer printed documents and forms, streamlined government procedures, such as prefilled forms using centralised data from government departments and federal agencies), could provide strong incentives through government policies and regulations through the widespread distribution of information. 2. Consumption and cognitive bias More information to correct behavioural bias The perfect consumer is a rational individual who makes consumption choices based on what is in his or her best interests. In reality, this is not always the case. Lawmakers and those 2

responsible for government consumption policy must therefore try and provide information that will prompt consumers to behave rationally. To this end, several studies have been carried out in the US in the last few years. Choice of pension fund In 2010, Harvard University carried out a study involving 400 people who had to decide which fund they should invest in. From a rational viewpoint, they should all have selected the fund with the lowest fees (255 dollars). The most expensive fund cost 561 dollars. The average fee selected by the 400 participants was 518 dollars, i.e. closer to the more expensive end of the fee scale. In a second phase of the study, the same 400 people were then given additional information and told to invest their money in a cheaper fund. The average fee only fell to 494 dollars and only 9% of the participants chose the fund with the lowest fees, despite the extra information given. Choice of when to have a free massage A group of individuals was given the choice between a free 15minute massage immediately or a free 20minute massage an hour later. The group was evenly split between the two options. They were then asked if they would like either a free 15minute massage one week later or a free 20minute massage one week and one hour later. The majority went for the second option. Extending the consumption timeline gave extra weighting to the extra 5 minutes of free massage which had held no sway whatsoever in the first scenario. The nextday jogging paradox Behavioural economics tests are in some ways similar to the games that economists and atomic war strategists created when Game Theory (founded by John Von Neumann) was first developed. For example, when an individual wants to go jogging, she may be faced with the following preferences and utility options: Does she prefer to go jogging now? This option has a weighting of 1 and a cost in terms of effort of 6 points. Or does she prefer to go jogging tomorrow? This option has a weighting of 0.5 but with a gain in terms of effort of 8 points. She will put off going jogging until the next day every day because her utility from going jogging the next day is 0 + 0.5x (6 + 8) = 1 compared to jogging the same day: 6 x 1 + 0.5 x 8 = 2. She will consequently never go jogging. The video rental club One example of a far from optimal purchase that many consumers are familiar with is that of the subscription to a video club or cinema. For example, a monthly subscription costs 75 euros while a single ticket costs 19 euros. The subscription therefore pays for itself after the fourth video or trip to the cinema. Nevertheless, consumers quickly realise that they do not go to the video club or cinema often enough to make the subscription worthwhile, either because there are no films in the cinema that they want to see or simply because they do not have the time. 3

Halffull or halfempty trolley Consumers in a supermarket were asked to fill their trolley with healthy products. At the end of three minutes, their trolleys were halffull. They were then asked to start again and fill their trolleys with products that they thought were less healthy or not healthy at all. This time, the exercise took them one minute and their trolleys were full at the end of it. The typical consumer needs guidance, especially when it comes to the financial services sector Economists have concluded from these examples that the positive choices made by consumers when backed by information campaigns such as Nothing is done automatically, you have to choose, were less frequent than the positive choices (or nonchoices ) made when preceded by enrolment by default or optout information campaigns. They therefore believe that if we hold consumers' hands and guide them through the decision making process, the result will be better than if we leave them to make their own decisions based on their rational beliefs. From an academic viewpoint, consumers appear to be very shortsighted, especially when it comes to making relatively complex financial decisions. The studies therefore highlighted two types of important bias in two types of situation: There are too many choices and they are too complex (e.g. that require a level of knowledge on a par with someone who has a university degree or diploma). In 2008, the US Federal Trade Commission (FTC), which is responsible for protecting consumers, decided to limit the number of ingredients listed on labels to ensure that consumers focused on the most important ingredients. Choices are presented in such a way that consumers do not always choose the best option (but often go for the default option). The FTC compared car insurance contracts available in the states of New Jersey and Pennsylvania. In New Jersey, the cheapest option was the default option, whereas in Pennsylvania, the most expensive option was the default option. In New Jersey, 79% of consumers chose the cheapest option but in Pennsylvania, only 30% did not select the most expensive option. When the options available are not complex, can consumers be left alone to make their own choices? And when the options available are complex and difficult to understand, should government policies be devised to ensure they do not make the wrong choices? Such government policies might have proved useful, for example, in helping to avoid the subprime crisis that broke out in the US in 2007 and then spread to the rest of the world in 2008. The crisis was a result of US consumers being allowed to take on more debt than they could pay back based on the positive equity in the mortgage values of their homes. These consumers were lowearners and therefore at greater risk of bankruptcy. They could have been dissuaded from borrowing to increase their consumption by heeding what was rational (i.e. failure to pay back the debt might result in them losing their homes and their savings). Alternatively, the government could have introduced legislation or the banks could have provided them with information or advice against borrowing so much. Providing consumers with information about the risks associated with these loans before they decide to buy is therefore essential. It would therefore be worth looking at ways of improving the decisions that consumers make, particularly when it comes to financial services. This sector poses a particular problem as most consumers are unable to grasp the complexities of the products offered to them by financial advisers. However, is there any point in toughening up the regulatory information 4

requirements when consumers are not necessarily capable of understanding the information they are given? Financial advisers that work for banks or insurance companies receive hefty incentives from their employers to promote the riskier products that are less beneficial for customers. Researchers have suggested that they should use more independent financial advisers. However, experience has shown that consumers trust a bank s financial advisers more, even when they are explicitly told that these advisers are not impartial and are acting in the bank s favour. One possible explanation for this is that consumers do not feel as though they are paying the bank s advisers whether they buy the product or not, whereas a visit to an independent financial adviser generates an additional cost, regardless of the outcome. Information and marketing campaigns influence consumers Government information campaigns to correct cognitive bias rely on knowledge of the psychology of the consumer or the citizen targeted. The marketing used by all major companies employs the same approach to attract consumers into certain stores and encourage them to buy certain products. After conducting a study on patterns of human psychological behaviour, Mindspace, the UK agency that monitors consumer behaviour, noticed that UK citizens were more affected by the question What will your friend think of you? than they were by Use a condom when it came to using a condom during intercourse to prevent sexually transmitted diseases. These studies show that consumers react to different stimuli: That affect their subconscious (using emotion to pass on a message is just as important for the government as advertising) That bring reciprocity into play (if we do a favour for someone, we expect them to return the favour) That affect the ego (how important I feel I am and the image I have of myself) That have an impact on how confident they feel (for example, French and UK citizens are more likely to fear being burgled or being a victim of crime than Scandinavians) The media and social networks wield a considerable degree of power in these areas. Some government policies based on a psychological study of the population have successfully achieved their targets at a reduced cost: The Swedish government s decision to use hotels more often than hospitals to house patients recovering from an operation or receiving treatment over a long time period Singapore s Yellow Ribbon programme designed to help rehabilitate exoffenders The UK government changed the wording of its reminders and notices of attachment sent to people that still owed tax. Since this was done, the number of people paying their taxes on time has soared from 55% to 85%, generating a gain for the UK Treasury of 250 million. However, it is impossible to generalise about the psychology of each individual and not easy to produce a onesizefitsall model. This field of study is still a workinprogress. Government agencies that use behavioural economics say that any conclusions should be taken with a pinch of salt: much is still not known about how psychological reactions affect behaviour. Some experts recommend ensuring that the media used by consumers are as transparent as possible, such as social networking sites. 5

Much remains to be done regarding the measures that can be taken to correct behavioural bias. Many in Europe believe that the way in which political decisions are announced to the general public, not the decisions themselves, can be improved through the use of behavioural economics. The examples in this paper reveal a behavioural bias in consumer decisionmaking. But public policy makers should also consider using the results of the principalagent theory. This theory looks at how information asymmetry between the principal and the agent is corrected, either through the use of incentives (moral hazard and incentive passed on from the principal to the agent to ensure that s/he generates a profit or acts morally) or the selections made (adverse selection enabling the principal to identify the good agents or the good products sold by the agents) in an uncertain universe and where there is information asymmetry. Consequently, consumer protection policies could therefore aim to encourage companies to comply with certain criteria (e.g. a governmentowned monopoly or oligopoly with regulated tariffs could be encouraged to go for a price capping formula rather than a costplus pricing strategy) to help consumers choose the best offers and steer clear of the worst ones (e.g. in the secondhand car market modelled by the US economist George Akerlof which assumes information asymmetry regarding the quality of the cars on sale, only the poorest quality cars are put up for sale). The signal given by the information (especially if the information is not as widely available or as valid as the regulator thought) merits a more indepth look. The Economic and Price Monitoring Bureau (1B) of the DGCCRF (Directorate General for Competition Policy, Consumer Affairs and Fraud Control) establishes and introduces measures to bolster economic transparency of the manufacturing and marketing processes for goods and services. This means that it is able to base its analyses in this area on objective and common factors. Its work involves price analysis and monitoring formation mechanisms for prices and margins, in conjunction with other relevant monitoring centres. It also produces economic studies for the Directorate and is tasked with its inhouse documentation and economic monitoring responsibilities. Lastly, it carries out statistical analyses of the consumer complaints register. Postal address: Ministère de l'économie et des finances DGCCRF Bureau de la veille économique et des prix (1B) Teledoc 042 59 boulevard Vincent Auriol 75703 PARIS CEDEX 13 Email address: Bureau1B@dgccrf.finances.gouv.fr 6