Questions and Answers on Behavioural Economics
European Commission - MEMO/08/748 28/11/2008
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Brussels, 28 November 2008
What is Behavioural Economics?
Behavioural Economics is a combination of economics and experimental research on behaviour, which examines and explains why consumers choose to shop and buy the way that they do, what influences them in their purchasing decisions and how these affect the market. It is a rapidly-expanding branch of study which received a boost in 2002, when a Nobel Prize was awarded to Daniel Kahneman "for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty".
Why is Behavioural Economics important?
Many areas of public policy rely on the behaviour of consumers and their ability to make the right choices in order to achieve certain goals, be it functioning markets or sustainable consumption. At European level, consumer behaviour is central to the debate over nutritional and environmental labelling, sustainable consumption, bank switching, consumer contract law, alcohol and tobacco policy, energy and mobile phone regulation. However, much of this policy is based upon the traditional economic view that the consumer is rational, pursues his/her own interests and is consistent in his/her choices. Behavioural economics challenges this view – with potentially significant implications for policy-making. Arguing that consumers are not perfectly informed and time-consistent, and that they can sometimes behave in ways that actually works against their own self-interest, behavioural economics creates new challenges for policy practitioners. Behavioural Economics could increasingly become a robust tool to test and tune policies, in the same way as the “wind tunnel” is used for cars. If consumers do not behave like machines, current policies based on this very assumption may be inefficient and may need to be revised, while new policies may need to take this into account when being devised.
What areas can Behavioural Economics be applied to?
Behavioural Economics can be applied to any aspect of consumer policy, from labelling to consumer rights legislation, from redress systems to financial regulation. But its relevance extends beyond consumer policy alone, to any public policy which seeks to influence consumers. Energy, telecoms, environment, health, agriculture, competition and education are all policy areas in which behavioural economics can have a significant impact. For example, experiments have shown that listing the neighbourhood average energy consumption alongside a consumer's own personal consumption on the energy bill can be a very effective way of encouraging consumers to adopt more energy efficient practices. In health policy, behavioural economic studies focussed specifically on organ donation showed that the number of donors in countries where citizens have to opt out of a default/automatic consent-to-donation system were far higher than in countries with an opt-in system. The finding that the default option matters can be invaluable when developing the most effective policies possible in these areas.
Are there any examples to date of where Behavioural Economics has been used previously in the development of legislation?
Policy-makers are increasingly recognising the importance of behavioural economics and the impact it can have on how successful a policy is. As a result, behavioural economists are being consulted more and more by legislators, in an effort to better shape policies to suit real consumers. Barack Obama, for example, has 2 behavioural economists amongst his advisors: senior economic adviser, Austan Goolsbee, and Cass Sunstein who co-wrote the much acclaimed book setting out the behaviouralist case in non-technical language: Nudge: Improving Decisions About Health, Wealth, and Happiness.
An example of where the European Commission drew directly upon behavioural economics findings when drawing up legislation can be seen in the recent proposal for a Consumer Rights Directive. This proposal includes a specific provision stating that "the trader shall seek the express consent of the consumer to any payment in addition to the remuneration foreseen for the trader's main contractual obligation". The decision to include such an article marks a change in the way that the EU institutions are now looking at consumers, and is based on the "default" theories set out in behavioural economic studies which show that consumers are more likely to accept an additional cost /option if they have to actively opt-out from it, rather than if they have the choice to opt-in to it (see annex below).
Another example can be drawn from the UK, where a report by the UK Better Regulation Executive and National Consumer Council showed that more information is not always the best way of informing consumers to help them make a properly considered choice. As a result of this study, the UK government has committed to testing regulatory information with consumers in advance, to see how useful it really is. A similar conclusion was reached by the US Fair Trade Commission (FTC) when it came to the disclosure of mortgage broker commissions. It was found that disclosure of the commission rate can distract consumers' attention away from the key price features of the mortgage, and could induce them to make worse decisions. As a result, the US dropped proposals for mandatory mortgage commission disclosures.
Why is the Commission organising a Conference on Behavioural Economics?
Through this first EU conference on behavioural economics, the Commission wants to bring together the top researchers, policy-makers and stakeholders to look at the new challenges that behavioural economics pose. It is a chance to tear down the walls between academics working on behavioural economics and the policymakers trying to interpret and influence consumer behaviour. The conference seeks to help researchers understand the kind of evidence that policy-makers need, while making policy-makers more aware of the importance of behavioural economics in shedding light on the nuances of consumer behaviour. The Commission wants to better understand how consumers behave, and why, so that EU policies can then be better designed. The Behavioural Economics conference seeks to find clear answers to the following 3 questions:
What are the next steps?
The conference is a first step towards looking at how behavioural economics can be further integrated into proposals put forward by the Commission, in order to create policies that better suit the needs of the EU citizens. Behavioural considerations could be included in Impact Assessments, which are conducted before any major proposal. The Commission also has 3 projects in the pipeline which link in with the issues that will be discussed at the conference. The first is a project which will be carried out within the 7th Research Framework Programme (FP7), investigating "Change in consumption, consumer markets and consumer behaviour". In addition, DG Health and Consumer Protection is planning to carry out a deeper investigation of consumer aspects of financial markets in 2009, using behavioural economic tools. The results of these investigations will feed into future Commission policies related to retail financial marketing. Finally, in 2010, the Commission will launch the European Household Survey, investigating issues related to consumer empowerment, assertiveness and information needs. The survey aims amongst other things, to derive better information on the ability of consumers to compare different offers on the market. All of these studies will feedback back into the Commission's work towards making the markets work better for EU consumers.
Did you know that:
If doctors want patients to protect themselves from the sun, it is more effective to warn against pimples than against skin cancer
Two thirds of Americans think their house has not fallen in value, even though 75% of houses have
If a candidate is listed first on an election ballot, s/he is can get up to a 4% increase in votes purely by default
Behavioural economics can offer explanations for these, and many other, seemingly irrational consumer trends and behaviours, and thereby help in some way to design policies which better fit the real needs and actions of consumers.
People prefer to do nothing rather than to make a change
Even if the costs of making a change are low and the benefits are high, people often choose to be "inert" or do nothing rather than actively make a change.
For example, a recent study conducted in Portugal found that 90% of mobile telephone subscribers do not use the cheapest tariff. The study revealed that, on average, consumers waste over 100€/year, because they choose to stick with the service that they have, rather than switch to a cheaper option. This implies that, even without changing operator, consumers could save over 700 million euros a year if they made the effort to use the most appropriate tariff for their purposes.
Too much information
There are limits on the amount of information we can take in – which means we may often filter out important details that could end up costing us dear. For example, when choosing a mortgage, most people focus on the interest rate and ignore adjacent costs such as tied insurance policies that can have a great financial impact on their total payments.
Moreover, studies have shown that people opt out of making a decision when faced with too many choices, because the instinct to avoid regret is greater than the perceived gains from making a choice.
A study carried out in California illustrated this point. Two booths selling jam were set up – the first had 24 varieties of jam on offer, the second had just 6 types. While more people were drawn to the stall with the larger variety initially, the sales figures told a very different story. Only 3% of customers bought a jar of jam from the stall which offered 24 types, while 30% made a purchase at the stall with the more limited selection. People were clearly overwhelmed or overly indecisive when confronted with too wide a choice.
For policy-makers, this is an important finding. Knowing that consumers can react adversely to too much information or choice can help in shaping a wide variety of different policy approaches - from what to put on food labels, to the compulsory information that industry and institutions should be required to give consumers.
It is all in the presentation
Consumers are greatly influenced in their decisions by how choices and options are presented to them – a fact that industry has been taking advantage of for years.
For example, studies have shown that, in school canteens, placing vegetables as the first food option that students encounter when they enter, or putting them on display at eye level, significantly increases the amount of vegetables consumed.
Another experiment was carried out on two groups of consumers who were buying a new car. The first group of consumers (A) were asked to choose the additional extras that they wanted included in their new car by adding them to a base model; the other group (B) had to delete the additional extras that they didn't want from the full-option model. The results were unambiguous: consumers (B) chose more options (with a higher final price) when they had to delete from a list, compared to when the consumers (A) who had to add to it.
If taken into account, such evidence can have a considerable impact on the
outcome of a particular policy. The classic example is organ donor cards. It has
been shown that replacing an opt-in system with an opt-out increases the overall
number of organs available while still giving the individual choice.
Source: Johnson and Goldstein (Science, 2003, Vol. 302, page 1338)
People often choose instant gratification over greater future rewards
People prefer a smaller reward now (immediate gratification) to a larger reward later. Likewise, if asked to do something unpleasant for either 2 hours today, or for 3 hours tomorrow, people will often choose to put off the task, even if the price will be higher in the future. So, while many would like to be slimmer, healthier or non-smokers, they often postpone the new exercise routine, diet or attempt to give up cigarettes until "tomorrow". This also applies to saving for old age or "a rainy day" – people are more inclined to spend their money now, even if they get less return for it, than to save it for later.
Similar evidence shows that if doctors want patients to protect themselves from the sun, it is more effective to warn against pimples (visible, short term cost) than against skin cancer (greater, but far-off cost).
In Alabama, the State Employees' Insurance Board has devised a new plan which seeks to re-balance the perceived enjoyment from living less healthily with the felt losses. From 2011, it will introduce a "fat tax", whereby obese employees or those with other side-effects from unhealthy living will have to pay $25 a month more in health insurance if they don't work to address these health problems. The rationale behind this is that the immediate cost that the employees will feel from having to pay higher insurance costs will be more of an incentive to change their living habits than the long term health threats.
People are overconfident
Most people are confident that their marriage has as good, if not a better chance of surviving than that of any other couple – despite divorce rates of more than 50% in many countries. Other surveys have shown that 80% of respondents rank themselves in the top 30% of drivers.
The result of this overconfidence is that people can overestimate their own logic, discipline and/or abilities. In the marketing world, this means, for example, that many consumers will take up an offer for a new credit card on the basis of an introductory discount interest rate, believing that once the discount rate expires, they will not borrow as much – yet this is rarely the case.
Cooling off periods, which are compulsory for some types of sales under EU consumer legislation, give the consumer a chance to reflect on what may have been an impulsive or overconfident purchase before fully committing to it.
Consumers care more about preventing a loss than making a gain
People are loss averse, and tend to place a heavier value on losses than on gains. They also tend to place a higher value on a good that they own than an object of identical value that they do not own (endowment effect). Consumers view parting with an already owned good to be a greater loss than the potential gain from acquiring another good of equal real value.
This helps to explain why professional market traders often hold on to investments that they have already made, rather than trade them in for assets that they might have preferred if they were choosing again from the beginning. In marketing terms, the "money back if you change your mind" offer also works on the basis that, once a consumer owns an item, they are far less likely to part with it again (i.e. return it), even if it doesn't fully live up to their expectations.