The implications of consumers’ biased decision making

As has been argued in the previous chapter, consumers’ decision making is influenced by several biases and heuristics which possibly lead to welfare-decreasing choices. However, even when behavioural insight can show that behaviour is affected by these biases and heuristics, government intervention is thereby not necessarily warranted.

Biases and heuristics can be very helpful and efficient in simplifying personal decision making processes. Also, consumers can learn from their mistakes, or be educated to improve their faulty decision making. Allowing people to make their own mistakes could therefore be a valuable and very efficient consumer protection policy strategy.

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a. Biased consumers acting against their own welfare

Even when behavioural insight can show that consumers are under the influence of biases, it does not automatically follow that this biased consumer decision making is welfare decreasing. Heuristics simplify decisions by requiring a limited amount of time and effort. Every individual utilises heuristics and biases to make decisions on a daily basis. Behavioural shortcuts help people to reach a decision which is relatively beneficial without having to weigh the consequences of every option. The decision reached might not be optimal considering the overall choice-set, but including the costs and benefits of the decision making process itself it might be quite close. Relying upon heuristics can be a welfare enhancing choice strategy in the light of information and deliberation costs (Kelman, 1998: 1583). Heuristics help when important decisions need to be made fast, such as in life-threatening situations (Gigerenzer, Todd and ABC Research Group, 1999).

Individuals can also employ biases and heuristics themselves, making behaviour seem irrational when it is not. For instance, paying high yearly fees for gym subscriptions might seem irrational when the consumer actually does not use the gym very often.

However, the subscription might be specifically employed by the consumer as a self-commitment device, without which he knows he would never attend the gym. The advance payment makes people want to get some benefit out of their ‘loss’, and makes them feel guilty for not attending the gym after they have paid a high subscription fee.

Biases may have other beneficial effects. Self-serving biases are one of the prime examples of cognitive quirks that, even though they impede optimal decision making, have beneficial effects nonetheless. Being positive about one’s own abilities is considered to be very healthy in social and clinical psychology. People are shown to have overly optimistic views of themselves. Only people that have been diagnosed with a clinical depression are shown to make accurate predictions about their likelihood of success. Positive illusions serve people very well, and promote their psychological well-being (Taylor and Brown, 1988; 1994). Also, people sometimes feel the need to help other people out, thereby abiding to social norms. Other regarding preferences, even though not necessarily rational from the perspective of self-interested individual rationality, can be argued to be highly efficient from a social welfare point of view (Stout, 2006: 27-35).

Problems arise though, when heuristics fail and render consumers vulnerable and easy to be taken advantage off, making ‘rational fools’ out of consumers instead of rational actors (Slovic et al., 2002: 339-40).¹²⁵ When choice is complex, or when the consequences of a choice lie mainly in the (distant) future, consumers can easily be deceived by their own biases and heuristics. Other examples include irregular decisions and choices that are so dreaded (or complex) that they cause inertia and consumers end up not making any decisions at all (Camerer et al., 2003: 108). Loewenstein and O’Donoghue criticise pre-commitment devices, claiming that these instruments of

125 See for a discussion of how sellers might be abusing consumer biases: below, section 4.3.2.

altering behaviour through self-imposed feelings of loss or guilt are a crude and insufficiently effective way of controlling one’s own behaviour (Loewenstein and O'Donoghue, 2006). These are situations which therefore should be assessed by policy makers to see whether social welfare could be improved.

b. Consumer learning and education

Another point of critique often offered by economists against behavioural insight is that consumer error does not by itself warrant a change in policy recommendations, as consumer error will be corrected by the market. Competition, learning by consumers and the education of sellers by consumers will drive out consumer errors (Epstein, 2006). The traditional economist’s argument proceeds as follows: people learn from their mistakes.

Confronted with the detrimental consequences of their previous decision, they improve their biased decision making and are then able to choose a more beneficial option when a similar situation arises. Learning effects will cause irrational behaviour to disappear over time; people should therefore be allowed to make their own mistakes (Kelman, 1998:

1583). Relying on consumer learning could be a very effective and efficient instrument to support consumer welfare.¹²⁶

Whether or not consumers are able to learn from their mistakes or can be educated to employ improved decision making strategies, depends on several factors such as feedback, spill-over effects, the cost of education and ability to improve the decision based upon the mistake. Also, the size of consequences might prevent learning and correcting mistakes.

ƒ Feedback: for consumers to know that decision making could be improved, they have to be aware of the flaw in their strategy. Feedback will only be taken into account when the consumer has an incentive to do so. When the consequences of the malfunctioning decision are small, consumers might not feel that improving their decision strategy is worth the trouble. Empirical evidence suggests that learning does not occur in every context and/or situation. Even highly experienced experts rely on misleading heuristics (Guthrie, Rachlinski and Wistrich, 2001: 782-3).

ƒ Spill-over effects: learning by one consumer can have spill-over effects on the decision strategies employed by other consumers, thus increasing social welfare.

The information strategies that are employed by sellers can also be improved when the learning process of consumers can provide feedback to sellers.

However, one person learning does not necessarily make other people learn the

126 Some evidence of consumer learning is discussed by Epstein (2008: 811-3). Agarwal et al. (2007) discuss how consumers are found to be best able to reach decisions about financial products when they are about 53 years of age. This would indicate that younger consumers have yet to learn, and older consumers have forgotten what they had learnt before.

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same lesson; this implies that the external effects of learning might cause not enough learning in the market (Bar-Gill, 2007: 8-9).

ƒ Cost of education: sellers have an incentive to educate consumers when they are better able to fulfil consumers’ true preferences than their competitor. They can thus be a valuable source of information. However, it might be more beneficial for sellers to rely upon consumer biases than correcting them.¹²⁷ This holds especially when the bias is hard to correct, such as in the case of information overload concerning highly complex information.¹²⁸ When sellers put new innovations in the market, consumers need to be educated about the advantages of this new product. Scepticism about new developments, cheaper products, high savings rates, low mortgage interest rates or other benefits and relying on incumbent firms stifles competition. The balancing act between knowing when a product is too good to be true or a great new innovation might be quite difficult for consumers. Even when consumers can nowadays disseminate information amongst each other, the risks remain that new innovations are mistrusted and are not at all or only after a long time picked up by consumers (Hviid, 2009).

Consumers can also opt for ‘education’ through information intermediaries, delegating individual decision making to privately employed experts with better judgement. Delegation to privately employed experts can however be prohibitively costly (Bar-Gill, 2007: 10).

ƒ Ability to improve: consumers should be able to correct their decision making strategy. As has been mentioned above, some mistakes might be irreparable or too costly to repair; relying on consumers to employ improved decision making might be ineffective in these situations. In order to correct decision making strategies, a similar situation needs to arise in which the improved strategy can be employed, preferably with a relatively short time span between both situations. People do learn from their mistakes but if the mistake is remote, the lesson might be forgotten. Even when a person receives a lesson in one situation, he might not apply that lesson in a slightly different context, because he fails to recognise the similarities. Some decisions are taken for a lifetime, or are very seldom. It is hard to learn from these mistakes.

127 See for a discussion of how sellers might be abusing consumers’ biased decision making below, section 4.3.2.

128 Next to severe information overload, other factors causing biased decision making are not easily counteracted, such as the dread factor linked to decisions involving death and huge suffering. Even when people know that the dread factor influences their decisions, this might not cause them to change their feelings or decision strategy. Procrastination, linked to present bias, is another flawed choice strategy that seems to be employed over and over again even when people know it is detrimental.

ƒ Size of the mistake: a mistake that has huge detrimental consequences could very well stimulate improvement in the decision making process for a next similar decision, but the question arises whether consumers should perhaps be protected from making this very detrimental mistake in the first place. Allowing the consumer to learn in this situation is very costly, and might not be warranted from a social welfare point of view.

To summarise, consumers’ biased behaviour is not necessarily detrimental, but it can be. Education and learning could overcome faulty decision making when appropriate feedback is provided, aided by spill-over effects. Education by sellers or information intermediaries, when costs of education are not prohibitively high, could also correct the market failure; however, there has to be an opportunity to improve the decision based upon the mistake. When the consequences of the mistake are particularly detrimental, learning by making mistakes might not be an advisable policy strategy.