Active consumers
and
economic performance
for
the
Danish Consumer Council
and the
Danish Competition and Consumer
Authority
CEBR – Centre for Economic and Business Research
Literature review written by
Peter Møllgaard
[email protected]
with the assistance of
Morten Eskild Friehling
15 May 2011
Executive summary
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Executive summary
Background
The Danish Consumer Council and the Danish Competition and
Consumer Authority have asked CEBR for a study of existing literature
on the relationship between consumer and competition policy and
productivity, growth and welfare. The aim has been an empirical and
policy oriented survey focusing mainly on supplier switching and
transparency, although more traditional types of consumer protection
that affect consumers’ behavior at the time of trading are also
treated. The literature survey
maps the channels through which consumers affect economic
performance;
identifies the most obvious instruments for consumer and
competition policy; and
gives examples on the effect of consumers on economic
performance.
Introduction
Active and competent consumers are a prerequisite for effective
competition in a market. If consumers do not react on price or quality,
then there is not much reason for suppliers to strive to deliver goods
with a reasonable relationship between quality and price.
Given the right circumstances, consumers may affect price and quality
significantly. The report offers examples that show that by leaving
unexploited price differences of up to 60 per cent on identical goods,
British consumers miss out on gains corresponding to around GBP 200
million in the markets for music and consumer electronics. Contrary to
this, American consumers of life insurance have gained around USD
165 million per year on price reductions of around 10 per cent that
resulted from the use of price comparison websites.
Consumers also have effect on the quality of goods and services. In
the U.S., hygiene control and labeling of restaurants have resulted in
consumers choosing better restaurants and a drop in the number of
food poisoning incidents of 20 per cent. Contrariwise, it is also well
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Executive summary
documented that if firms are not allowed to compete by advertising
nutritional content then quality is reduced: goods become more
unhealthy.
Consumers are willing to pay more for products of documented
quality. They are, for example, willing to pay about 15 per cent more
for certain products with eco labeling.
However, the report also shows that it is a difficult and complex task
to ensure the precise mix of incentives and regulation that can release
this large potential. There are a number of obstacles, and the design
of consumer policy instruments is decisive for whether they contribute
to the activation of consumers in the end.
There are three major reasons why consumers do not always act as
expected: Search costs, switching costs and bounded rationality.
Search costs are pecuniary, psychological and physical obstacles to
consumer search. Prices in markets with search costs may be
excessive without triggering a reaction from consumers. The larger
the fraction of well-informed consumers is, the lower will the price be,
so
consumer
policy
should
aim
to
inform
as
much
and
as
inexpensively as possible.
Switching costs are the psychological, pecuniary or physical costs that
are related to switching to a new supplier and that the consumer does
not have to incur if she stays with her current supplier. This may also
mean that the price can be set way too high because the supplier has
an installed base of loyal customers to skim. Consumer policy should
aim at reducing artificial switching costs as much as possible.
Bounded rationality occurs in market where products or contractual
conditions are so complex that consumers have a hard time to assess
what the trade really implies. It is, for example, reasonable to assume
that the consumer cannot assess how often different types of
insurance events occur when signing an insurance policy because it
requires data and computations that are difficult to comprehend for
the normal consumer. In this case, consumer policy should aim at
protecting the consumer against abuse.
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Executive summary
The
survey
identifies
three
major
types
of
consumer
policy
instruments to activate consumers and to overcome the three major
obstacles (search costs, bounded rationality and switching costs):
A. Information gathering and comparison aim in particular at
lowering search costs;
B. Help to make informed choices at the time of purchase aims in
particular at mitigating the effects of consumers’ bounded
rationality; and
C. Help at switching supplier aims in particular at reducing
switching costs.
The three types of instruments often affect more than one of the
three challenges simultaneously.
Gathering and comparing information
Gathering and comparing information have as a primary goal to
reduce search costs. The instruments can be divided into three
categories:
1. Price comparison websites that in principle may make it easy
for consumers to identify the best purchase. It is a challenge
that consumers do not always choose the best buy suggested
by a website; that consumers often do not use websites/search
engines as actively as they could; and that firms may
manipulate (some) websites in various ways. For these reasons
it is important a) that consumers are free to determine how
results are sorted and ranked; b) that there is access to a
website
that
is
independent
of
suppliers;
and
c)
that
consumers find websites natural and easy to use.
2. Standardization of price information is an attempt to reduce
the complexity of information comparison by ensuring that list
prices follow a common structure. An example is the use of
Annual Percentage Rate (APR) in connection with the pricing of
credit.
The
challenges
are
that
standardization
may
be
circumvented by offering several versions of a product or by
(not) including add-ons. A solution could be to insist that the
price should include all common elements and services, i.e.
that the price is all inclusive. Such all-inclusive prices are best
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Executive summary
when extra fees are compulsory and identical across all
consumers.
3. Information about and regulation of quality make it possible for
consumers to make informed choices. The requirement that
restaurants display the result of public hygiene inspection at
restaurants leads to better quality (hygiene) because quality
becomes a part of competition.
Helping consumers make informed choices at the point of sale
Help at making informed choices at the time when consumers make
their purchasing decision aims primarily at preventing suppliers’ abuse
of consumers’ bounded rationality. These instruments give consumers
the possibility of either making informed choices or of correcting their
mistakes at a later point in time.
The literature identifies three groups of instruments that may limit
abuse of bounded consumer rationality:
4. Binding offers with a certain minimum duration provide
consumers with time to search for more information and to
give the purchase decision extra consideration.
5. In-store price comparisons require that consumers get access
to information about rivals’ prices at the point of sale. This
increases competition and gives the consumer knowledge of
whether further search would pay off. The challenge is that it
may be difficult to ensure that the information is correct. This
could possibly be solved by requiring legally that the supplier
must provide correct information that is up to date.
6. Cooling-off periods give consumers a right to cancel a contract
or to return a product and get a refund from the supplier
during a given period. This limits the possibility for abuse of
the consumer at the time of purchase. The challenge is that
cooling-off
periods
may
undertake
unnecessary
give
risks
consumers
(moral
incentives
hazard)
and
to
that
consumers may underestimate the costs of returning a
product. For these reasons it is important a) that cooling-off
periods are of sufficient duration to allow consumers to gain
experience with the product, b) that consumers are reminded
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Executive summary
of the expiry of the cooling-off period and c) that it is simple to
return the product.
Instruments that may help consumers switch suppliers
Helping consumers to
switch
suppliers contributes to lowering
switching costs. Switching costs give suppliers power over those
consumers who are already customers (the ”installed base”) and this
may lead to higher prices and to the exclusion of rivals.
The literature identifies three main groups of instruments that make it
easier for consumers to switch supplier:
7. Cancellation rights allow consumers to terminate a contract
with a given notice so she can be released from her contractual
obligations and switch to a better offer. The challenge is that
the supplier may enter long-term contracts that entail bargains
up front with the expectation of “ripping off” consumers later.
An example is the “financing” of a free mobile phone through
the price of use (phone and/or text). Cancellation rights work
best when conditions are easy to comprehend and when
consumers are aware of and willing to switch to better offers.
8. Product attribute portability (e.g. number portability) is the
possibility of transferring one or more product attributes from
one supplier to its rival. This lowers switching costs. The
challenge is that portability has to be rather immediate in
order that consumers find it attractive. This can be done by
standardizing the attributes that are to be transferred.
9. Consumer information portability aims at breaking the current
supplier’s monopoly on detailed information about consumers.
This informational advantage implies that competing suppliers
cannot tailor offers to a given consumer. Challenges are that
information may be coded differently by different suppliers
(and thus difficult to exchange) and that the information also
can be abused which could make consumers reluctant to
release the data for exchange. The challenges may be met by
standardizing the information and by asking a third party to
collect and give access to the data.
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Executive summary
Examples
of
consumers’
role
in
relation
to
economic
performance
The report goes through three examples of how consumers may make
a difference for competition and efficient use of resources in order to
render the literature survey and the discussion of policy instruments
concrete. The three examples are retail markets for electricity, the
market for home and personal protection insurance, and the use of
labeling.
Consumers and the liberalization of electricity market
Since 2003, Danish consumers and small businesses have been
allowed to change supplier of electricity, but only relatively few
consumers have actually exploited this possibility in Denmark relative
to consumers in Norway, Sweden and Great Britain. This is due to a
series of factors: In Norway and Sweden, households have much
larger electricity consumption due to the more common use of electric
heating in these
countries. In Great Britain, British Gas has been
allowed to bundle contracts of electricity and gas
and this practice
increases the value of switching due to ’dual fuel’ discounts and also
due to the fact that British Gas is recognized as a reliable supplier by
many consumers. In Denmark the default supplier is the company
with a supply obligation and this default system contributes to the
slow switching behavior.
Consumers could be made more active and competition would
improve by a better price comparison site, the introduction of a Data
Hub and the use of smart meters in combination with dynamic tariffs.
A good price comparison site which lowers search costs already exists
(elpristavlen.dk). This site may be improved if it could be used
directly to contract with a (new) supplier. This would require that the
comparison site get access to information on consumers, e.g. through
a Data Hub, see below.
Distribution system operators and suppliers of electricity possess a lot
of information on consumers of electricity. These basic data are used
to pay for the electricity consumers receive and for payable tariffs.
Standardization and sharing of basic consumer data in a Data Hub
could precipitate supplier switching. The Data Hub should be available
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Executive summary
to all interested parties. This would make it possible for default
suppliers’ rivals to give consumers concrete, tailored offers based on
each individual consumer’s basic data.
Smart
meters
allow
hourly
readings
of
consumers’
electricity
consumption and would make it possible for consumers to react to
electricity prices to a higher degree. This may in and of itself increase
the price awareness of consumers but today it is only about 20 per
cent of the price consumers pay that vary with the wholesale price of
electricity. Consumers will be motivated to react to prices if dynamic
tariffs are introduced. Such dynamic tariffs are high when the
wholesale price is high and low when it is low. Besides encouraging
consumers to be active participants in the competitive process, an
added advantage is that consumers’ electricity consumption will at the
same instance be more sustainable.
Consumers and home and personal protection insurance
Insurance markets may be opaque to consumers because insurances
are complex products and because insurance policies are often written
in
a
legal
language.
Family
Basic
Insurance
II
(Familiens
Basisforsikring II, BF II) is an attempt to design a standard policy that
contains home and personal protection with family public liability
extension. In principle this standardization increases comparability
across different insurance companies but in reality BF II is offered
with a number of different add-ons and these may complicate
comparisons because policies are not identical at the end.
Many insurance companies offer to collect all insurances of a
consumer or a household against a discount. This increases both
search costs and switching costs for each product.
Many Family Basic Insurances are sold through labor unions, others
through
banks.
There
is
a
price
comparison
site,
www.forsikringsguiden.dk, allowing consumers to compare insurance
policies and prices. This site decreases search costs.
Switching costs may be lowered through a shortening of the
cancellation notice which often is rather long (up to a year if
cancellation is to be free). Another way of reducing switching costs is
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Executive summary
through insurance brokers – provided they are independent of
insurance companies and used correctly.
Active consumers and labeling
Labeling is used to give consumers the possibility to make active
choices in markets in which suppliers or producers know much more
about the product than consumers do. Labeling helps consumers sort
different products and may be thought of as an information system.
There are two types of labeling: A label that is awarded as a result of
a certification based on a number of criteria for what the product or
the service is allowed to contain, e.g. the Danish Ø label for organic
food, the Nordic Swan or the EU eco-label for environmental criteria
or the E label for ethical online trade. The other type is “informative
labeling” that objectively list product characteristics and content. In
Denmark such labeling is governed by the Danish Institute for
Informative Labeling.
Labeling
often
has
a
positive
effect
on
consumers.
However,
consumers react differently to the same information: First-time
purchasers are for example more likely to use labeling actively.
In
general, the effect of labeling depends on whether the label is worthy
of trust and comprehensible.
Trustworthiness may be achieved through the involvement of public
institutions in the certification processes. Consumer trust of ecolabeling increases with the degree of public control of the labeling
process for example.
Comprehensibility of the labeling may be achieved through simplicity:
the label should summarize as few well-defined characteristics as
possible. Multi-dimensional labeling may confuse many consumers.
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