Over theyears, it has been possible to understand the nature of a number of thesebiases – or deviations from rational decision making – which now support manyof the propositions of what has become known as ‘behavioural economics’. Forexample, people have been found to have:Cognitive limitations (‘bounded rationality’) –people cannot collect and process all the available informationpotentially relevant to making a rational decision.Consequentbehaviour:· People simplify decisionmaking by adopting simple heuristics (or procedural rules-of-thumb); forexample, simplifying the problem by focusing only on price and style (ignoringtechnical information).· People may rely on the firstpiece of relevant information they receive; for example, the first in a list ona comparison website.· People are influenced by theway a choice is presented to them (framing) even when the alternativepresentations are equivalent; for example, preferring A over B based on thequality and prices of the goods, but reversing this preference presented as’50% off’if B’s price is.
Biased beliefs – peopleoften act as if they distort objective information on probabilitiesConsequentbehaviour:· Peopletend to place a greater weight on both very low probability events and oncertainty; for example, buying both lottery tickets and expensive insurancethat covers 100% replacement. How firms can exploit behavioural traitsin consumers With fully rational consumers, itis usually advantageous for firms to provide potential customers with all therelevant information on product specifications and price. However, withbehavioural consumers, firms may find advantage in obscuring information sothat consumers pay a higher price or buy a lower quality than would be best forthem. Consumers may be provided with too little information to make anappropriate comparison with alternatives.
Perhaps paradoxically, the sameeffect can be achieved by providing too much irrelevant information such thatthe decision-relevant data is buried in the small print and so ignored. Firmscan also adapt their pricing strategies to take account of the fact that theirpotential customer base may include both rational and behavioural consumers.Price obfuscation Even thoughmost consumers compare prices, they do not necessarily pay attention to the wayprices are presented to them. The only information that should be relevant tocustomers is the final price they have to pay. However, that is not alwaysobvious because firms sometimes present information about the final amountcharged in ‘drips’, with insurance, credit card fees, baggage charges, etc.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 justbefore purchasing, but they can no longer be bothered to search for a betteroffer.
Prices canalso be presented in a way that makes them appear particularly attractive.Consumers may believe a ‘half price’ offer must be good value even though theprevious price was twice as much as the price at which it could have beenpurchased elsewhere. ‘Buy one get one free’ also sounds like a great deal, butit may not be if the price of one unit is inflated or the second unit would nothave been purchased otherwise. Retailers are experts on howconsumers respond to these alternative pricing strategies, and can sometimesuse them to benefit at the expense of consumers.
This should not be taken toimply that such offers are always bad for consumers. Genuine price cuts are anessential part of the competitive process. Behavioural economics providesinsight into how various price obfuscations can be used strategically, butindividual examples need careful appraisal before deducing that a pricingstrategy is anticompetitive in a particular market. What remedies are appropriate for anintervention founded on behavioural economics? Suppose wecan identify a market where customers are prevented from choosing theirpreferred product because it is difficult to obtain and process the rightinformation. Once such a market failure has been identified, we need toconsider whether it can be corrected without creating a new distortion. Thebest economic advice for intervention, as always, is to act as close to thesource of the problem as possible. For example, suppose information is beingpresented in a way that obscures the key decision-relevant facts, typicallyincluding the final price that has to be paid. An appropriate interventionwould be for firms to be required to highlight such information up-front in aclear and transparent manner.
The aim is to help consumers act more closely inline with the rational ideal that makes a competitive market attractive –consumers get the product they want and at a price that reflects cost. Remediesthat require clearer provision of information to final consumers may increasecosts a little, but they are unlikely to have additional consequences that areharmful. Greater care is needed for other remedies which directly interferewith consumer choice.
Remedies designed to changeconsumer behaviour are increasingly used by the UK competition authorities.Examples include:Provisionof transparent price information to facilitate price comparisons:· Someairlines were adding additional payment card charges to headline prices forflights, even when cards were necessary to make a purchase. Consumers onlydiscovered this late in the booking process so it was difficult to compareprices. The OFT used consumer protection legislation to require airlines toinclude debit card charges in all headline prices, both on the airline’swebsite and in its advertising. Additional credit card fees are permitted aslong as they are presented clearly and transparently. It is now easier forconsumers to compare prices before getting committed to a particular flight.
· An interest rate can becalculated in many alternative ways. Lenders are required to present interestrates for consumer loans in a standard form known as APR (annual percentagerate). It is arguable whether APR is the best way for a consumer to understandthe cost of a loan, but it does provide a standard by which the offers fromdifferent lenders can be sensibly compared, and so facilitates competition.
· Restrictions on marketingcomplementary products, such as insurance, at the ‘point of sale’.· Paymentprotection insurance (PPI) is mostly sold at the same time as a consumer takesout a loan (‘point of sale’). Customers could buy PPI from a separate providerbut they almost never shop around because they are either unaware that it ispossible or worried about a gap in coverage or simply cannot be bothered. Thisconfers a near monopoly advantage at the point of sale, and the absence ofcompetitive pressure allowed very high prices to persist.
MakingSense of Complex Choice Situations· Price complexityThe idea isthat firms sometimes price their products, or present information about theirprices, in unnecessarily complex ways, and that this complexity obstructscompetition and exploits consumers.In many cases, these innovationshave led to greater economic efficiency in pricing. For example, it is nowpossible for airlines to vary the prices of seats on individual flights minuteby minute so as to match demand to supply, reducing the waste of empty seats.Products that were previously sold as single-price packages can now be moreeasily broken down into separately-priced components, allowing purchases to betailored to consumers’ individual requirements. As the example of airlineprices also illustrates, price discrimination has been made easier.Minute-by-minute price flexibility allows higher prices to be charged topassengers who do not want to commit their travel plans far in advance and whoare not willing to substitute a cheap destination for an expensive one. Butthis, too, can be seen as efficiency-enhancing, since price discriminationhelps to ensure that goods are supplied whenever the total benefits toconsumers exceed the cost of production.
· Choice overloadChoiceoverload is said to occur when consumers face somany options that the quality of their decisions declines, or they feeldissatisfaction with their final choices, or their motivation is so underminedthat they avoid choosing altogether. An extreme version of this claim has beenpopularised by Barry Schwartz (2004) in a book whose premise is that when thenumber of options becomes too large, ‘choice no longer liberates, butdebilitates. SocialInfluences on BehaviourPeople canlearn both from their own experiences and from observing the experiences ofothers and how these may contribute to welfare.Imagine that we see someone wetrust or like, they are eating at a restaurant and so we decide to eat theretoo.
This is a social influence on individual behaviour. It could have arisenin two distinct ways. We could have been looking for somewhere to eat and takenthe person’s presence in the restaurant as a reliable indication that this wasa good place to eat. Alternatively, we could have had no prior intention ofeating at a restaurant, but we identify with this person and the group that heor she belongs to; they are part of our set and so we decide to eat at thisrestaurant too, as this is what our group does. In the one case, the behaviourof others transmits useful information about how best to satisfy our desiresand we act on this information.
In the other, our desires or preferences areinfluenced by those we associate with, and that is why we follow what they do.This vignette raises the question of how the presence of such social influencesmight create opportunities and set challenges for policy.Conformismcan also arise when the value to an individual of consuming something dependson the number of other people consuming it. In this case, the behaviour ofother people can be a source of information of a rather different kind. When wewatch a film or TV programme or we go to an exhibition, part of the pleasure isexperienced at the time of consumption; but part of the pleasure comes laterfrom being able to discuss the experience with others. Critically, this laterpleasure depends on whether others have also seen the film, watched the TVprogramme, and so forth.
As a result, it can make sense for individuals toprefer to watch what others are watching even when their natural tastes mightpoint them in a different direction. This is sometimes called the water-coolereffect because of the way that people in offices often congregate incommunal spaces for a chat. ConclusionThe report mainly dealswith marketing implications of behavioural economics. First part of the reportdiscuss about behavioural economics and how it is different from traditionaleconomics. Behavioural economics can help to explain why search and switchingcosts might arise, and how consumers actually make decisions. From a regulatoryperspective, however, understanding such processes is important only as a meansto an end.