In the second blog in the Consumer Financial Protection series, we explore insights from behavioral economics that could fundamentally impact the design of legislation and regulation for consumer protection in finance.
Neo-classical economic theories like expected utility hypothesis and efficient market hypothesis are based on the assumption that the consumer is a rational agent. However, recent insights from behavioral economics point out that the consumers do not always behave as time-consistent, rational utility maximizers. Consumers are, in fact, beset with a number of cognitive limitations and biases which influence their decision making and make them acts in ways contrary to the traditional model of hyper-rationality. We will explore some of the insights from cognitive psychology and experimental economics that could impact the design of consumer protection legislation and regulation in the future.
The work of behavioral economists Daniel Kahneman and Amos Tversky provided early insights into consumer behavior. Their seminal work found evidence to suggest that consumers do not make decisions that expected utility theory predicts. The central insights of this theory help explain observed consumer behaviors such as:
a. Loss Aversion: People are extremely sensitive about losses and exhibit deep seated loss aversion to even small amounts of money. In fact, there is evidence that individuals are more sensitive to losses than profits – in fact, people value moderate losses more than twice as much equal sized gains (Tversky and Kahneman: 1991). This translates into financial decisions that would be at significant variance from the theory of expected utility.
b. Incorrect Probability Calculations: People have a tendency to overweigh small probabilities and under-estimate risks with larger probabilities. This explains why people more readily buy insurance on refrigerators and TV sets, but are less likely to buy life or accident coverage. Individuals also tend to be more sensitive to differences in probabilities at higher probability levels.
c. Response to Framing: People make different choices in identical situations because of the way the choices have been framed for them. The way in which a problem is described can be responsible for upto a 30-40% shift in preferences (Barberis and Thaler: 2003). The fact that framing can fundamentally impact consumer choice means that investor welfare could be seriously compromised in the absence of countervailing regulation.
d. Mental Accounting: The process people use to formulate financial problems for themselves is called mental accounting (Avgouleas: 2006). One classic case of mental accounting is “narrow framing”, where individuals evaluate a particular gamble (or financial transaction) as if it were independent of everything else in the world and not assess its utility in terms of the gamble’s effect on the individual’s overall wealth.
Biases and cognitive limitations:
Human beings also exhibit biases and other cognitive limitations that can contribute to poor decision making. In the context of financial products, consumers are prone to take decisions that can have negative future consequences for themselves (also called internalities).
a. Self-restraint: Consumers often behave in ways that compromise long-term well-being for short-term gains. This bias of present consumption out-weighing future welfare manifests itself in various forms such as the failure to save for retirement. It is also observed that consumers discount future benefits/costs in a time-inconsistent manner. For example, if offered $100 now and $200 a year from now, a consumer is likely to choose the immediate $100. However, when offered $100 five years from now and $200 six years from now, a consumer is likely to wait the additional year even though the it is the same choice she makes five years from now. This time inconsistent, present biased model of discounting is referred to as hyperbolic discounting.
b. Herding: Consumers often mimic behavioral patterns of peer leaders or peer groups, leading them to ignore signs and indicators that would lead a rational consumer to take different decisions. Such irrational behavior is fueled by overconfidence (in peer leaders or rating agencies and in assessments of new financial products) and can often threaten systemic stability. History is replete with examples of irrational behavior leading to economic bubbles, from the Tulip mania in the 1600s to the present financial crisis caused partly by the real estate bubble in the USA.
c. Information Overload: In the previous blog post, we mentioned Akerlof’s seminal study of the used-car industry, where information asymmetry leads to market inefficiency. Contrary to expectations, a regulatory response to provide the consumer with additional information (beyond a point) can be counterproductive. This happens due to the phenomenon of information overload, where the consumer is unable to assess the quality and amount of information given to them. Examples of this phenomenon include consumers casually flicking through tens of pages of terms and conditions when insurance is bought online, without understanding the risks and clauses involved.
Systemic irrationality and regulatory responses:
There are several limitations to the use of insights from behavioral economics in consumer financial protection.
Work in experimental economics argues for the emergence of rational behavior in the context of a repetitive market activity. Consumers display rational behavior in the long run, through a trial and error adaptation process and repeated market activity and spurts of irrationality are characteristic only of the short run. So, consumer irrationality, it is argued, can only be a factor in the policy of consumer protection, not the starting point. Second, behavioral economics is yet to come up with an all-encompassing theory of the market or consumer choice that can challenge the existing neo-classical theories; it has only pointed out deficiencies of the latter. Third, behavioral economics does not formulate any normative principles, which can be used either for empirical testing as economic models or for normative use as a guideline to an efficient market mechanism.
Even if consumer irrationality is an exception to the norm of rational behavior, the insights of behavioral economics alert us to the possible risks of systemic irrational behavior and the consequence this can have on the financial system. Any regulatory mechanism should therefore be designed to be able to respond to systemic irrationality. However, regulators should be required to tread carefully before intervening in a situation of perceived systemic irrationality. At the very least they must have to demonstrate indications of irrationality in the system, provide plausible explanations of how such irrationality can have a financial system-wide impact and finally make clear the case for how their proposed regulation will be effective in countering the irrational behavior.
To ‘nudge’ or not to ‘nudge’?
If consumers cannot maximize their own welfare (due to lack of cognitive capability or financial literacy), it is argued that regulation needs to ‘nudge’ the consumers into making those decisions which reflect the presumed judgment of what consumers would want, were they fully informed or well advised. This approach is referred to as libertarian or asymmetric paternalism.
The idea behind libertarian or asymmetric paternalism is not to restrict the consumer’s autonomy; rather it seeks to counter the harmful effects of cognitive biases without affecting the choices of the less behaviorally challenged consumers. Some of the suggested regulations include increased pluralism in information disclosure formats and in the prescribed volume of information reaching different investor classes, mandated use of structured and edited investment contracts that consumers can easily comprehend and mandatory use of long term performance reports. These suggestions imply that regulators must drop the ‘one size fits all’ approach as consumers’ decisions vary depending on factors such as income, education, age, attitude and the type of financial product they consume.
There are, however, strong arguments against the ‘nudge’ principle on the grounds of its interventionist approach, implied restrictions of choice and possible impact on rational consumers. These arguments speak to the heart of debates around behavioral economics and consumer protection today.
1. Backstrom, Hans. Financial consumer protection- goals, opportunities and problems. Economic Review. 2010
2. Campbell, John Y., Jackson E Howell et al. Consumer Financial Protection. Volume 25, Number 1. Pp 91-114. Journal of Economic Perspectives. 2011
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4. Emilios, Avgouleas. Cognitive Biases and Investor Protection Regulation: An Evolutionary Approach. 2006. Available at SSRN: http://ssrn.com/abstract=1133214
5. Kahneman, Daniel and Tversky, Amos. Prospect Theory: An Analysis of Decision under Risk. No. 2, Volume 47. Econometrica. 1979
6. Kahneman, Daniel and Tversky, Amos. Loss Aversion in Riskless Choice: A Reference-Dependent Model. 106, Quarterly Journal of Economics. 1991