Behavioural Economics: Nudging its way in consumer policy

This year’s surprise winner of the Nobel Prize in Economic Sciences is Richard Thaler, a prominent behavioural economists. The surprise factor does not come from a lack of prolific and ingenious academic life, rather from the nature of the field of research that Prof Thaler revolutionised. Not many behavioural economists have won the highest honour in the discipline, despite it having gained an established place not only within academia, but also within government departments around the world. After all, behavioural theories challenge some of the credos of mainstream economics, such as consumers granted with perfect information and possessing perfect rationality. Behavioural economists seek to uncover consistent cognitive and behavioural biases in human and to incorporate those into more realistic representations of the world.

One policy area where behavioural economics has dominated the dialogue, is consumer policy. The reason for this is quite obvious – in the marketplace, consumers would be most likely to possess the biases identified by behavioural economists. The better informed and more experienced retailers can exploit these biases in order to increase their profitability, sometimes via fraudulent and immoral methods. The harm from these dishonest actions, known to consumer protection experts as “consumer detriment”, is difficult to identify and measure and thus to be used to draw robust economic conclusions. However, ideas from behavioural economics can help us paint a fuller picture of this harm to consumers.

Detriment can be related to the individual experience of those consumers for whom something goes wrong, capturing the idea that some aspects of this type of detriment will depend on the psychology of the person concerned. Consumers suffering from behavioural biases can sometimes be exploited by retailers, which may then justify a policy enforcement.[1]

Behavioural biases and how to exploit them

Consumers typically place disproportionate trust in retailers, with whom they have had past experiences. Another side of this “status quo bias” is seen when consumers stick with their current supplier so long as it offers acceptable quality at an acceptable price, without reviewing whether a better deal could be achieved in the market.

The presence of “time-inconsistent behaviour” affects their choices: for goods which have an immediate cost but bring benefits in the future, firms have an incentive to charge a high upfront fee and a fee per usage that would otherwise not allow them to make a profit (i.e. gym subscriptions). This allows sophisticated consumers to commit themselves to using the good, while allowing firms to extract surplus from naïve consumers, who overestimate future usage.[2]

Even when consumers have a good amount of information available, they may be “non-rational”, as they may over-weight or under-weight the risk of experiencing detriment. For instance, a consumer who has recently experienced a problem with a certain product may overweight the probability that such a problem will happen again.

People may have “limited foresight” in their decisions. For example, a consumer might decide to purchase a product, knowing that he can later benefit from its return policy. However, he may fail to recognise that returns can add additional costs in terms of postage costs; he may not have enough time within the return window; or, simply he may forget to return it altogether!

Experienced and cunning retailers may easily infer these behavioural biases and exploit them for profits. For example, retailers sometimes present information about the final amount charged in “drips”, with other fees, such as insurance, credit card fees, baggage charges, etc. These are added on only after the emotional commitment to a purchase has been made. Similarly, people can be caught by a time-limited offer that runs out just before purchasing, but they can no longer be bothered to search for a better offer. ‘Buy one get one free’ also sounds like a great deal, but it may not be if the price of one unit is inflated or the second unit would not have been purchased otherwise.

Retailers may also find it advantageous to obscure information so that consumers pay a higher price or buy a lower quality than what would be best for them. They may be provided too little information to make an appropriate comparison with available alternatives. Perhaps paradoxically, the same effect can be achieved by providing too much information: what is actually important is buried within pages of irrelevant information and is therefore ignored.

The nudging hand

Perhaps, Thaler’s most famous legacy consists of bringing “nudge theory” into prominence. In the context of consumer policy, nudging would gently push the vulnerable individual into more advantageous actions in the marketplace. At first glance, nudging sounds like a good complement to standard consumer protection policies of quality controls and remedies. After all, if it is the inherent human psyche at least partly responsible for allowing retailers to create consumer detriment, why not attempt to fix it?

Yet, this type of guidance may cause a certain level of moral dilemma on part of a governmental body. It should not be a regulator’s decision to substitute their own preferences for choices made by an individual, even if those consumer preferences are less than optimal. Unless the behavioural bias has its roots in a consumer information problem, intervention would take an unelected regulator into a paternalistic authority. One solution to this ethical puzzle is what is referred to as “asymmetric paternalism”, which imposes little cost on rational individuals. An example of such a regulation would be giving buyers the right to rescind purchases within a well-advertised and sufficiently long time period. This would be of benefit to people who have purchased say, an office juicer in the heat of a communally health-conscious moment, while imposing no cost on other consumers.[3]

To what extent have nudges and behavioural methods “saved us from ourselves” is still up to debate. Nonetheless, a Nobel Prize to a behavioural economist is a gesture by the mainstream establishment that maybe we are not so rational after all.

[1] Europe Economics. 2007. “An analysis of the issue of consumer detriment and the most appropriate methodologies to estimate it”, Final Report for DG SANCO.

[2] DellaVigna, Stefano, and Ulrike Malmendier. 2006. "Paying Not to Go to the Gym." American Economic Review, 96(3): 694-719.

[3] Camerer, Colin and Issacharoff, Samuel and Loewenstein, George and O'Donoghue, Ted and Rabin, Matthew, Regulation for Conservatives: Behavioral Economics and the Case for 'Asymmetric Paternalism' (April 1, 2003). University of Pennsylvania Law Review, Vol. 151, p. 1211, 2003; Columbia Law and Economics Working Paper No. 225.