What we (actually) do in markets


Much of economics and therefore of public policy is based on assumptions about what people do in markets. Behavioural economics (BE), a discipline which looks at our actual behaviour in markets, is just starting to get a bit of attention of Australia.

Despite many comments about this ‘new’ behavioural economics, it is not really a new discipline. Keynes used behavioural economics (though not in any controlled experimental manner) in predicting that a small rise in nominal wages would stimulate the economy – provided of course that people did not act rationally by discounting their wage rises back to real terms. They didn’t. Herbert Simon’s profoundly insightful concept of ‘bounded rationality’ has contributed greatly to the thinking in BE, and Kahneman and Tversky’s prospect theory is the parent of modern behavioural economic research. That the discipline isn’t new is well supported by the number of Nobel prizes already received by its adherents (the list includes Daniel Kahneman, Vernon Smith, and George Ackerlof, and many would also include the recent prize to the game theorists Robert Aumann and Thomas Schelling). What is new, however, is the recent emerging understanding of BE’s importance in public policy decision making.

What is it? At its simplest, behavioural economics concerns itself with how people actually make decisions in economic situations. Note the emphasis on actual and not how people are supposed to make decisions according to some normative economic theory about rationality.

For a simple illustration of the differences between a neo-classical and behavioural economic approach take the issue of choice. In neo-classical terms, more choice is better. In BE terms, it may not be. The classic illustration of this is the tastings experiment conducted in an upscale supermarket — where the opportunity was given to taste 6 jams in one situation, and to taste 24 jams in the second situation. Though the 24-jam table attracted many more consumers to stop and taste, of those who did taste, 30% purchased jam in the 6-jam condition, with only 3% purchasing in the 24-jam condition (Iyengar & Lepper, 2000). This is a classic decisional conflict situation also known in behavioural economics as choice overload.

People look for rationales to choose one item over another and where this becomes too complex they can either walk away from the market (deadweight loss as in the jam situation) or pick ‘whatever’. One of the public policy implications is that in some situations it might actually suit a firm to create a choice overload situation. For example, if you are a former monopolist or oligopolist facing newly deregulated markets and fresh competition, one strategy is to make choice quite difficult for consumers — they are less likely to switch in those circumstances (economists call this the creation of a confusopoly) quite apart from sheer human procrastination. Government policy that doesn’t take choice overload or complexity of decision making into account and remedy that problem so consumers can drive competition will leave potentially powerful incumbents with a market advantage. The result is weaker competition, with competitors finding it much harder to gain a significant foothold.

With all the benefits that competition delivers, it’s good to remember that competition isn’t the end in itself — benefit for consumers is the end game. The introduction of competition in directory-enquiry services is an example of assuming that creating competition is the goal — as opposed to considering how consumers will react. With over 100 directory enquiry numbers available, the total overall use of directory services has fallen (Use of alternative free internet directory services has had some effect here as well). There appears to be increased confusion and also a perception of higher costs. In fact most residential consumers are now paying higher prices even with many more cheap providers in the market (UK National Audit Office Report 2005).

In other areas of behavioural economics, the public policy implications of failing to understand how people behave can also be costly in human terms. Behavioural economics repeatedly shows, in both its experimental and empirical studies, that the decision-making context matters for consumers and for citizens. Framing, for example, is crucial. People will choose differently depending on whether an option is framed as lives saved or lives lost (when the statistical outcome is actually identical). How you frame a choice for citizens in their decision-making about organ donations has immense implications for the outcome. The chart below illustrates the organ donation rates of a set of European countries — the rates on the left average about 15% while consent to use one’s organs in the circumstance of accidental death is about 97% on average in the other countries.

The low-rate countries frame the decision as a ‘tick the box if you want to leave your organs for medical purposes'; the high-rate countries frame the decision as a ‘tick the box if you do not want to leave your organs for medical purposes’. For citizens, this is not the same decision.

The economic behavioural biases in consumer decision making in the market are quite well known by firms, and more specifically by the marketing executives of firms. In fact, credit card profitability is largely based on the consumer behavioural bias of time-variant preferences, specifically of hyperbolic discounting. Hyperbolic discounting refers to people not having a fixed discount rate to weigh present and future costs and benefits – the discount rate increases the shorter the time period outstanding. So, for example, it’s easy to open the savings account and intend to put in $100 a month to save for a ‘rainy day’ (low discount rate) but very hard to actually do that with the $100 in hand when a night out on the town looks like much more fun (high discount rate). That’s why people intend to pay off the credit card when purchasing on it, but when time comes to pay, our discount rate has changed and many people will fail to pay it off despite the high cost of this form of credit.

The main centres of behavioural economic research in the world are in the US and the most notable is Harvard University. Lawrence H Summers, former US Treasury Secretary and current Harvard President, describes himself as a behavioural economist. Much of the behavioural economic work has been carried out in financial markets — especially perceptions of risk and related decisions. The Boston Federal Reserve Bank is one of the top research institutions in the area — and we all know about ‘irrational exuberance’ a behavioural economic description of actual market behaviour.

Despite the credentials of both the institutions and people involved in BE, there has been a notable lack of interest in this discipline in Australia in both academia and in government policy-making circles. New Zealand, however, with the lowest savings rate in the OECD, has been taking an interest. The KiwiSaver scheme, due to be implemented in 2007, is based on behavioural economic research and is structured to use the power of defaults; the default in this case is that a savings plan is established for an employee and money is paid into that account by your employer unless you tick the box to opt out. The result of this initiative on the national savings rate will be fascinating to observe as no behavioural ‘experiment’ of this type at a national level has ever been conducted previously.

In Australia the Treasurer, with his May budget elimination of tax on superannuation benefits, may be banking on more than just ‘rationality’ in people’s responses. The notion of having your retirement income tax free is a very potent one. The Treasurer may be triggering one of the most powerful behavioural biases studied – loss aversion. People see ‘losses’ almost twice as powerfully as they do monetary gains. So, if they put more money into their super account, all those earnings over the time period will not be ‘lost’ to the taxman. That kind of incentive may even shift hyperbolic discounting behaviour that characterises non-compulsory pension schemes world wide — it is extremely hard in voluntary schemes to get people to save for their retirement even in cases when employers are matching dollar-for-dollar and the potential savers are numerate people who can do all the calculations and really understand the benefits. While economists by and large dislike the Treasurer’s initiative, history may show that he’s picked it right in terms of people’s behaviour. My bet, given what we know of behavioural economics, would be with the Treasurer on this.

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