Behavioral economics and competition

PRESENTED TO Hong Kong Competition Commission

PRESENTED BY Neil Lessem, Ph.D.

31 October 2016

Copyright © 2016 The Brattle Group, Inc. Agenda What is behavioral economics?

Why does behavioral economics matter for competition?

Examples of behavioral biases

Case study: Drip pricing

Conclusion

1 | brattle.com What is behavioral economics? Neoclassical economics assumes that: ▀ People hold rational preferences ▀ Individuals maximize utility, firms maximize profits ▀ People act independently on the basis of full and relevant information

Behavioral economics, on the other hand: ▀ Uses insights from psychology and experimental economics to explain actual consumer behavior ▀ Explains why consumers in certain contexts act in a way that does not follow from the traditional economics framework

2 | brattle.com Homo Economicus or Homo Sapiens?

3 | brattle.com Obligatory Adam Smith slide Important behavioral theorists ▀ Adam Smith (1759) explored loss aversion, concerns about fairness and justice ▀ Vernon Smith (1976) introduced experimental economics ▀ Kahneman and Tversky (1979) developed prospect theory ▀ Loewenstein and Prelec (1992) and David Laibson (1997) discussed hyperbolic discounting ▀ Colin Camerer (2003) researched the interface between cognitive psychology and economics ▀ John List (2004) took experiments out of the lab and into the field ▀ Dan Ariely (2008) framed biased decisions as being predictably irrational ▀ Thaler (2008) popularized behavioral economics with the publication of “Nudge”

4 | brattle.com Many competition agencies interested in behavioral economics

▀ Federal Trade Commission (USA)

▀ Consumer Financial Protection Bureau (USA)

▀ Competition Markets Authority (UK)

▀ Authority for Consumers and Markets (Netherlands)

▀ Australian Competition and Consumer Commission (Australia)

▀ Behavioural Insights Team (the Nudge Unit) (UK and Australia)

Tend to be consumer and competition focused ▀ Market reviews popular instrument 5 | brattle.com Why does behavioral economics matter for competition? In the presence of behavioral biases, consumers may: ▀ Find it hard to assess available information and compare across similar products/services ▀ Overestimate future use, underestimate cost, and overweigh the present ▀ Resort to heuristics, or rules of thumb, when faced with too many options ▀ Defer decisions indefinitely

It may be the case that firms are implicitly exploiting these biases to gain more market power than would follow from traditional models: ▀ Firms may introduce search and switching costs through pricing frames and complexity to lessen price competition ▀ Firms may use pricing frames to influence consumer behavior ▀ Firms may introduce implicit bundling and tying by exploiting consumers’ inertia and default biases

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Why does behavioral economics matter for competition? Cont. The Office of Fair Trading (OFT) in the UK defined the role of the consumer in driving competition as a three-step process: ▀ Access information about available offers ▀ Assess offers in a rational manner ▀ Act on this analysis by purchasing the product or service that offers the best value

At any stage, behavioral biases can result in consumers no longer rewarding the firms that provide them with the most benefit, but instead reward those that best exploit their biases

7 | brattle.com When is competition likely to be affected? We seem to be wired for some biases ▀ Chimpanzees get same results as humans in ultimatum game

Source: Keith Jensen, Josep Call, and Michael Tomasello, “Chimpanzees Are Rational Maximizers in an Ultimatum Game,” Science, 318 (5 Oct. 1007): 107.

8 | brattle.com When is competition likely to be affected? But biases can be untaught ▀ Firms and market professionals behave differently to amateurs (consumers) ▀ Some very small societies have different social equilibriums

Bad behavior may not be corrected by market forces ▀ Consumers – inertia ▀ Rivals ? − Shapiro yes, Gabaix and Laibson no

Generally dealing within bias framework works better at addressing issues than trying to educate through

9 | brattle.com Examples of behavioral biases Framing and anchoring effects

Choice overload

Loss aversion

Status quo bias

Intertemporal effects

Overconfidence

10 | brattle.com Framing and anchoring effects The way information is presented can affect consumer preferences ▀ The evaluation of probabilities and outcomes may be different when the same problem is framed in different ways (Tversky and Kahneman 1981)

▀ Where consumers are required to make a choice along a spectrum, they can be heavily influenced by anchoring effects − Ariely, Loewenstein, and Prelec (2006) asked MIT students to bid on items using the last two digits of their social security numbers as an anchor. They found that people with higher social security numbers paid up to 346 percent more than those with low numbers 11 | brattle.com Choice overload Increasing consumer options increases both their desire to delay decision- making, and to choose the default option or rely on heuristics (rules of thumb) ▀ Iyengar and Lepper (2000) showed that people are more likely to purchase gourmet jams or chocolates or to undertake optional class essay assignments when offered a limited array of 6 choices rather than a more extensive array of 24 or 30 choices. Moreover, participants actually reported greater subsequent satisfaction with their selections with a limited selection of choices 12 | brattle.com Loss aversion Consumers tend to feel the pain of losing more powerfully than the pleasure of gaining ▀ Loss aversion is often used to describe the endowment effect − In Kahneman (1990)’s well-known coffee mug experiments, he showed that indifference curves could intersect, and that students who’d been given coffee mugs or pens valued them more than if they had the option of buying a mug or a pen ▀ Tversky and Kahneman (1979) developed prospect theory to show that decisions are not always optimal; consumers’ willingness to take risk depends on framing (i.e. losses loom larger than gains)

13 | brattle.com Status quo bias Consumer behavior is strongly influenced by status quo bias and inertia, or the tendency to stay with a previous decision or not act at all ▀ Johnson and Goldstein (2003) examined the impact of policy defaults on the decision to become an organ donor, finding large effects between opt- in and opt-out programs

14 | brattle.com Status quo bias can be due to inertia or an implicit recommendation by authority

Source: Faruqui, Hledik, Lessem (2015)

15 | brattle.com Intertemporal effects Research shows that consumers place more emphasis on the present and heavily discount the future ▀ Laibson (1997) used the decisions of a time-inconsistent consumer to explain a model that accounts for self-control problems where agents have difficulty sticking to their long-term goals ▀ Loewenstein and Prelec (1992) showed that people are not always time consistent and proposed a framework to analyze discounted utility anomalies ▀ A 2004 U.K. BIT experiment of 600,000 credit card holders showed that the study subjects were 13% more likely to accept a low introductory offer for a short period even though they would have been better off with the slightly higher interest rate lasting for a longer period of time

16 | brattle.com Overconfidence Consumers tend to over-estimate their abilities, motivation, and knowledge ▀ A familiar empirical example is consumers signing up for gym membership and then not using it ▀ This could be explained by both overconfidence and hyperbolic discounting of future pay-offs ▀ Compared to naïve consumers, who exhibit time-inconsistent behavior, sophisticated consumers, who realize their bias and try to anticipate future performance, can bind themselves to contracts to achieve their goals − Apps and websites (e.g. Pact and StickK, respectively) use monetary rewards/fines to Source: January 2013 review of influence users’ future behavior GymPact on iMedicalApps

17 | brattle.com Biases are not independent and can be present throughout the decision making process

Access Assess Act Framing effects cloud Demand consumers’ Supply preferences Consumers

Well- Inertia limits the over-estimate Hyperbolic Firms are informed, extent of search their abilities, discounting incentivized rational motivation, and leads to time- to deliver consumers Lack of knowledge inconsistent what the reward knowledge preferences consumers best-value limits available Inertia limits want firms options switching Consumers

resort to

heuristics when faced with too many options

18 | brattle.com Case study: Drip pricing

▀ Definition: Drip pricing is the practice of advertising a low headline price for the purpose of attracting consumers, then incrementally disclosing additional components (e.g. taxes, fees, delivery charges) to the price − Exploits consumers inertia by increasing their search costs − Taps into consumers’ loss aversion as they may have already decided to make the purchase upon seeing the headline price ▀ The U.K. competition agency, OFT, was concerned that this practice impeded competition by limiting the extent to which consumers were searching across firms based on price (as headline price is not a good indicator of final price) ▀ Similarly, in 2015, the Federal Court of Australia found that Jetstar and Virgin airlines breached the Australian Consumer Law by failing to disclose additional booking and service fees (fined $750k); and the Australian competition agency, ACCC, found that Airbnb and Vacciones eDreams made misleading representations by failing to disclose mandatory service fees and/or cleaning fees (both undertook to improve pricing practice) 19 | brattle.com Conclusion “A competitive market leads to better prices, products and choice for everyone.”

Is a market competitive if the majority of customers are choosing worse or more expensive products?

Profit maximizing firms have an incentive to understand and exploit consumer biases to gain or retain market power ▀ The market may or may not correct for this

Behavioral economics are a new tool in the competition economist’s toolkit ▀ Enhance existing tools, not replace them ▀ Understanding homo sapiens rather than homo economicus will allow us to better champion competition

20 | brattle.com Live long and prosper

21 | brattle.com Presenter Information

NEIL LESSEM Senior Associate │ Sydney [email protected]

Dr. Lessem assists utilities, policymakers and technology firms across North America, Asia, the Middle East and Australia on rate design, energy policy, innovative pricing, experimental design, technology adoption and policy impact measurement. He has broader expertise in energy, applied microeconomics, environmental economics, and behavioral economics. In his graduate studies, Dr. Lessem conducted extensive research examining consumer adoption of environmentally-friendly products and conservation behaviors, utilizing both field experiments and utility data.

Dr. Lessem holds a Ph.D. and M.A. in Economics from the University of California, Los Angeles and a B.Bus.Sc in Economics and History from the University of Cape Town (South Africa), where he graduated with top honors.

The views expressed in this presentation are strictly those of the presenter(s) and do not necessarily state or reflect the views of The Brattle Group.

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