Behavioural Economics and the Economics of Regulation

Abstract

Behavioural economics draws upon fieldwork, experiments and research in disciplines such as psychology for building blocks to construct economic analysis that is more descriptively realistic and both augments and qualifies traditional economics as a tool for designing policy. Though behavioural economics has attracted much attention and respectability in the past decade or so, its roots date back to work undertaken in Europe a century ago and in the US in the middle of the twentieth century. Whereas economists traditionally have seen choice as an optimising activity subject to given preferences and a well-defined budget constraint, behavioural economics sees everyday life as a process in which humans with limited cognitive capacity try to cope with both information overload and the absence of relevant information and knowledge by evolving targets for what seems feasible and systems of rules for trying to find ways of meeting these targets. Some decision rules may be fast and frugal means of arriving at choices that do not result in needlessly poor attainments. However, much of what is known about how people actually behave implies that many people could be doing a lot better for themselves in many situations if only they were aware of the limitations of their ways of coping with the world and were motivated to find and apply improved decision rules. Poor search strategies limit the competitive pressures faced by firms and hence may have longer-term impacts on welfare via reduced productivity growth or innovation. However, in designing policies to promote better search by consumers one must remember that many consumers are also workers: higher productivity and better or cheaper goods may sometimes come at the cost of people having to work harder. To the extent that firms are aware of shortcomings of consumers' decision-making processes, they may be in a position to apply this knowledge to manipulate choices, for example by how they frame information that is presented to consumers. Tendencies for consumers to lack self-control and to fail to reflect on the longer-term implications of their choices can very easily result in poor choices when credit is easily available. Regulatory policies could do more to promote careful reflection by consumer by erecting hurdles to delay choice, as well as by measures to make it easier for consumers to make comparisons and see the financial implications of particular choices. In designing such policies there is scope for integrating them with policies aimed at the promotion of self-funded retirement and environmental wellbeing. The paper ends with detailed case study discussions of problems of choice in the markets for building renovation services and financial services. In the former, problems of finding good value for money are increased by the one-off nature of much of the work and by combination of shortages of trades-people relative to demand and large numbers of potential suppliers to approach for quotations. The environment is also conducive to consumers ending up overcapitalising in their renovations. In the market for financial services, the balance of risk-taking with property speculation and suchlike is stacked in favour of the loan providers, whilst the chances of inexperienced speculators getting into difficulties are enhanced because they are prone to use decision rules they have picked up from others belatedly and in simplified form. The implications of borrowing and superannuation choices should be made much more transparent to consumers, along with the futility of trying to beat the market rather than investing in market index funds.