What does Behavioural Economics mean for Competition Policy? Office of Fair Trading, March 2010. Matthew Bennet, John Fingleton, Amelia Fletcher, Liz Hurley & David Ruck
This paper looks at whether behavioural economics fundamentally changes our understanding of competition policy. We argue that behavioural economics is an important incremental advance in our understanding, just as informational economics was before it. But this does not mean that all previous economic models of competition and markets are now irrelevant. For the most part, they still provide valid and valuable insights. Importantly, behavioural economics does not question our belief in competition policy as a tool for making markets work well for consumers.
Nevertheless, the existence of behavioural biases does have a number of implications for the way in which markets work. Behavioural biases on the consumer side emphasize the importance of the demand side in making markets work well, and the important synergies between consumer policy and competition policy. Behavioural biases may also have implications for anti-competitive behaviour. In spite of this, behavioural economics does not necessarily imply more intervention. Markets can often solve their own problems and even where they can’t, there are dangers inherent in over-paternalism limiting consumer choice. Behavioural economics also emphasizes the difficulties that authorities can have in trying to correct for such biases.
Homo Sapiens exhibits systematic biases in the way he views both the world and markets. (…) are there ways in which behavioural biases might lead to systematic biases in the models of markets and competition on which we have been relying?
Behavioral economics no fundamental shift because/but:
- Behavioural economics does not mean that all previous economic models are negated
- Both competition policy and demand-side intervention are crucial tools for making markets work well for consumers
- The market may find its own solutions to any problems, but we can not blindly assume the market will solve everything
- competition (or consumer) authorities can face difficulities in trying to correct for such biases. Eg.: Behavioural economics tells us that simply providing more information may not be a good solution when consumers have problems assessing such information
Ad #4: It is well documented that consumers do not always read and understand the information provided to them; For example, see (November 2007), Warning: Too much information can harm, A final report by the Better Regulation Executive and National Consumer council on maximising the positive impact of regulated information for consumers and markets.
- Market power
- Asymmetries in information between consumers and firms
- Externalities not captured within consumers’ preferences
- (?) Behavioural biases
Behavioural economics (& biases):
- highlights that consumers may find it hard to assess information and compare across products
- allows us to better understand the underlying causes of search costs (which affect access) and switching (which limits ability to act)
- makes clear that existing problems within the consumer decision-making process are more entrenched and prevalent than we had believed
Markets work well when there are efficient interactions on both the demand(consumer) side and the supply (firm) side. On the demand side, confident consumers activate competition by making well-informed and well-reasoned decisions which reward those firms which best satisfy their needs. On the supply side, vigorous competition provides firms with incentives to deliver what consumers want as efficiently and innovatively as possible. When both sides function well, a virtuous circle is created between consumers and competition.
Failure of either side of the circle can harm the effectiveness of markets
Dynamic competition may also be affected by consumer biases within the market. Over time this evolutionary role of competition implies that the average efficiency of the market increases for all consumers. This role is diminished when consumers no longer reward those firms that provide them with what they really want but, instead, reward those that best play on their biases.
In order for consumers to drive competition by their active, effective, and rational part in this virtuous circle, they ideally need to:
- Access information about the various offers available in the market. Affected by biases e.g.: consumers tend to look at relative costs rather than absolute search costs.
- Assess these offers in a well-reasoned way. Affected by biases e.g.:
- incorrectly anticipating risk, underestimating or overestimating future use, or overweighting the present
- use rules of thumb
- distracted by the way in which information is framed and presented
- Act on this information and analysis by purchasing the good or service that offers the best value to the customer. Affected by biases: e.g. overconfidence, can create inertia
Firms’ Reactions to Consumer Biases
- Accessing information. Firms can make it more difficult for consumers to
perform optimal search. E.g. add-on services, adding clauses, drip-pricing
- Assessing offers. E.g. obfuscating prices or increasing choice or complexity
- Acting on information and analysis. E.g. increase switching costs (play on inertia), use defaults and automatic enrolments, or use time limited offers to inhibit switching
But: there is a growing empirical literature that provides evidence to support the notion of non-rational behaviour by firms, see Armstrong & Huck (2010) Behavioral Economics as Applied to Firms: A Primer.
Problems in Markets can be Self-correcting
Market Solutions: the market may require a catalyst in order to change from an equilibrium in which all firms want to exploit consumer biases to an equilibrium in which all firms want to help consumers by revealing their prices. Potential catalysts: media, or advisors & intermediaries (e.g. consumer organizations).
Power of Learning: Even if firms have an incentive to mislead consumers this may not be possible (for long) if consumers learn from their mistakes. There are clearly limits to learning.
Self-regulation occurs where firms opt to join schemes that require them to
behave in particular ways.
Intervention Can Potentially Do More Harm than Good
All errors which [man] is likely to commit against advice and warning, are far outweighed by the evil of allowing others to constrain him to what they deem his good.
John Stuart Mill, (1859), On Liberty.
- We want solutions that solve the problem, but we do not want to remove consumer choice
- Tthere is no guarantee that authorities will necessarily improve the market or not create unforeseen consequences elsewhere. It may be that authorities simply do not have the level of expertise required to make delicate interventions
- Authorities might have behavioural biases as well
Caution us against being too paternalistic even when behavioural biases point to problems within the market.
Lessons for Design of Remedies
- There will always be times – just as there has always been – when intervention is necessary.
- Other tools include consumer enforcement, consumer education, and (in
the UK at least) market studies and investigations. There is also potential for
authorities to advocate legislation in a particular market
- Example of a positive intervention may be obligations on firms to require them to help consumers make decisions
A further concern that can arise around interventions to solve problems associated with consumer biases is that such interventions can be inherently redistributive. In many markets, the gains that firms make from exploiting consumer biases will be to some extent passed back, through the competitive process, to customers who do not exhibit those biases. In this case, there is effectively a form of cross-subsidy between customers, and this may be unwound with intervention. This does not imply that such interventions should not be made, but it is important to be aware that there can be losers as well as winners in such situations.
Where behavioural biases appear to be creating problem, some may advocate abandoning competition for regulation. We discussed above the dangers of over-paternalism and limiting choice. Competition authorities have a key role in reminding government of the benefits that competition and choice bring. In doing so, however, they need to be cognisant of the available evidence on behavioural economics and its implications.