Behavioural Economics – the lessons for regulators
02 December 2016
Behavioural Economics (BE) has long influenced firms’ commercial and marketing strategies. In recent years it has also grown in popularity with competition and regulatory authorities, as seen most recently in the energy and retail banking market investigations by the Competition and Markets Authority (CMA). A discussion exploring how regulators have applied BE and the lessons they have learned took place at the PwC sponsored Beesley lectures.
Mike Walker, Chief Economic Advisor to the CMA explored how the CMA has harnessed BE’s increased ability to diagnose and improve on poor consumer outcomes. Walker argued that, until recently, regulators had often overestimated rationality and underestimated behavioural biases (in itself a behavioural bias), leading to ineffective interventions. He mentioned that he expected that the UK’s downstream energy market, with 20+ providers offering a homogenous product, would be competitive. However, consumers’ inertia has resulted in low switching rates and rising prices with an estimated overall consumer detriment of £1.4bn per year. Consumers’ behavioural biases were mentioned to have resulted in poor outcomes in many other sectors, such as low cost airlines, with the extensive use of drip pricing in the past. Walker’s starting point was that although these biases have long been recognised by economists, we now know that they are not random and that consumers are “predictably” irrational. This makes it possible to intervene and improve consumers’ outcomes.
When should regulators intervene?
Walker provided a useful framework to guide regulators and firms to decide if, and when, intervention to remedy behavioural biases may be warranted. For example, this may not be the case when the identified concern is likely to be short-term one and could be resolved by market evolution – e.g. Price Comparison Websites (PCW) entering and addressing concerns about consumers’ inertia. Furthermore, when some consumers are active and engaged and some are not, the latter often (but not always) subsidise the former. But intervening to redistribute welfare across these consumer groups may not improve things as it can dis-incentivise active engagement and is likely to harm rather than help consumers in the long term.
Whilst Walker provided a finely balanced and well qualified approach to guide regulators in making the right decisions when facing behavioural biases concerns, Philip Booth, Academic and Programme Director at the Institute of Economics Affairs presented the case for a less interventionist approach. He warned that intervening to mitigate consumer biases may result in fewer opportunities for consumers to learn from their mistakes. He also argued that regulators (or their staff) can be guilty of committing the similar errors and falling foul of the same biases that we commonly see in the average consumer. So, although BE has expanded the regulators’ toolkit, that should not necessarily translate into increased intervention.
What have we learned?
Walker identified four broad lessons:
1) Test, Test and Test - often the right remedial measure is not obvious and the only way to find out is to test it. He gave the example of a remedy requiring mortgage brokers to disclose their commissions to reassure consumers that the advice they receive was unbiased. But experiments showed that doing so focused consumers’ attention on the level of the commission and resulted in fewer consumers selecting the cheapest mortgage.
2) Test, Learn, Adapt - ‘obvious’ or ‘sensible’ remedies do not always work, and may even backfire. For example, the Office of Fair Trading (OFT) attempted to reduce annual charges for personal current accounts by giving all consumers a summary of their annual charges. The theory was that making these costs clearer to consumers would increase current account switching and reduce charges. However, when the FCA reevaluated this remedy six years later, it found it had little to no effect. Post evaluations in this field are critically important. Once you learn that interventions may have not worked as intended, you also need to be prepared to go back to the drawing board and adapt them.
3) Go with the grain - Changing consumers’ behaviour by providing additional information has often proved ineffective. But this is to be expected, if consumers were not paying attention to even less information pre intervention. Acting on the supply side may prove more effective, for example, by allowing PCWs to get access to a database to identify consumers that have not switched energy supplier.
4) Rules of thumb - Consumers optimise using rules of thumb. Wherever possible, regulators should attempt to make these shortcuts sensible. For example, when a simple option exists alongside several more complex options, consumers may be attracted to the simple option which they can understand. Regulators should aim to break down over complexity, provided that simple options are better for consumers.
What does this mean for businesses?
As Walker stressed, BE has significantly helped regulators to be better at identifying the causes of inefficient market outcomes and at designing more effective remedies. However, while supply side concerns are usually confined to few markets, consumers’ biases can and do pervade almost every economic activity. This explains the regulators’ significant focus on demand-side concerns over the last few years. Walker’s lesson “test, learn and adapt” feels like a programme for ongoing intervention. Therefore, irrespective of whether one believes the balance between demand and supply-side interventions is now set at the right level, BE seems here to stay. The implications for companies are not just limited to the investigations they may be involved in. They may extend to ex-ante compliance to reduce the risk that their commercial strategies may trigger interventions.
If you’d like to find out more about PwC’s BE team and how we help solve the challenges you may face, please contact a member of the team.