Behavioural economics: a game changer for regulators?
12 November 2012
By Neha Georgie, PwC Economist
Steffen Huck, Professor of Economics at UCL, and Amelia Fletcher, Chief economist at the OFT, presented an engaging Beesley lecture on the applications and implications of behavioural economics. Key themes discussed are summarised below.
What is behavioural economics?
Behavioural economics refers to deviations from the “hyper-rationality” that is assumed in most conventional economic theories. Importantly, behavioural economics puts empirical work based on controlled experiments at the forefront of understanding behaviour, rather than theoretical models. The field continues to grow in influence: it is now central to consumer policy as practised by the OFT and finding its way into competition policy.
What does it mean for me as a consumer?
A key message was that it is not as easy for consumers to process information as classical economic models assume; they may instead use “rules of thumb” as a basis of decision-making. Firms may also actively seek to complicate consumer choices, rather than making them transparent. An example is the pricing of calls made from hotel rooms. Firms understand that consumers tend to make decisions based on the room price and often underestimate how much they will use the hotel phone. This leads hotels to set low prices for rooms relative to costs. While consumers who do not make calls from hotels benefit, research has shown that consumers lose overall. Crucially, competition may make consumers worse rather than better off, if it all focuses on the basic room price rather than quality and the cost of additional services such as phone calls, laundry and minibar prices.
What does it mean for firms’ behaviours?
It is not just consumers that deviate from hyper-rationality. Firms may too. For example, they may focus on being more profitable than their most direct competitors rather than maximising profits, and might also imitate competitors’ strategies and behaviours, instead of making their own decisions.
The most striking conclusion was that firms might make similar but disparately formed choices which then appear collusive. Firms learn about each others’ business strategies and behave accordingly - especially relevant as firms are interested in relative, rather than absolute, success. Such behaviour could make it difficult for competition authorities to ascertain if firms are genuinely colluding and harming consumers.
Another significant implication was that competition does not always have the power to eliminate consumers’ biases. An example would be a three-part tariff for phone pricing plans, which puts consumers into light, medium and heavy categories by design of tariff plans. As consumers tend to misestimate their own demand, firms stand to profit from both heavy and light users, with the former over-using (so paying excessive charges) and the latter under-using (so paying unnecessarily more). Importantly, competition cannot change such behaviour – consumers will seek contracts that they believe fulfil their needs even when afforded greater choice.
What does it mean for regulatory policies?
The overarching message was that consumers and firms both hold behavioural biases that regulators must account for when formulating policies. Viewing both consumers’ and firms’ behaviour through the lenses of accessing, assessing and acting on information helps identify where regulation may be necessary. Consumers can make errors and switch less, which can soften competition. Firms can exacerbate this by confusing consumers. Some airlines’ fees for flights booked online, for instance, do not state upfront that the use of a debit card for payment will lead to a surcharge. Ineffective competition results as consumers are unable to easily compare prices. An intervention by the OFT has led to voluntary undertakings by airlines to ensure that headline fees will be all-inclusive in future.
Behavioural economics continues to evolve; the challenge for regulators will be how they use these developments to intervene without becoming overly paternalistic. The challenge for companies will be to integrate insights from behavioural economics into the cases they make to regulators and government.
Email: Neha Georgie
Tel: +44 (0) 20721 32 046