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
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What is behavioral economics?
  Neoclassical economics assumes that:
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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:
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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
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Homo Economicus or Homo Sapiens?
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Obligatory Adam Smith slide
Important behavioral theorists
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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”
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Many competition agencies interested in
behavioral economics
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Federal Trade Commission (USA)
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Consumer Financial Protection Bureau (USA)
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Competition Markets Authority (UK)
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Authority for Consumers and Markets (Netherlands)
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Australian Competition and Consumer Commission (Australia)
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Behavioural Insights Team (the Nudge Unit) (UK and Australia)
  Tend to be consumer and competition focused
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Market reviews popular instrument
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Why does behavioral economics matter for
competition?
  In the presence of behavioral biases, consumers may:
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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:
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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:
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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
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When is competition likely to be affected?
  We seem to be wired for some biases
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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.
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When is competition likely to be affected?
  But biases can be untaught
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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
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Consumers – inertia
Rivals ?
− Shapiro yes, Gabaix and Laibson no
  Generally dealing within bias framework works better at addressing
issues than trying to educate through
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Examples of behavioral biases
  Framing and anchoring effects
  Choice overload
  Loss aversion
  Status quo bias
  Intertemporal effects
  Overconfidence
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Framing and anchoring effects
  The way information is presented can affect consumer preferences
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The evaluation of probabilities and outcomes may be different when the
same problem is framed in different ways (Tversky and Kahneman 1981)
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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
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Choice overload
  Increasing consumer options increases
both their desire to delay decisionmaking, and to choose the default
option or rely on heuristics (rules of
thumb)
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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
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Loss aversion
  Consumers tend to feel the pain of losing more powerfully than the
pleasure of gaining
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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)
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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
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Johnson and Goldstein (2003) examined the impact of policy defaults on
the decision to become an organ donor, finding large effects between optin and opt-out programs
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Status quo bias can be due to inertia or an
implicit recommendation by authority
Source: Faruqui, Hledik, Lessem (2015)
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Intertemporal effects
  Research shows that consumers place more emphasis on the present
and heavily discount the future
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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
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Overconfidence
  Consumers tend to over-estimate their
abilities, motivation, and knowledge
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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
influence users’ future behavior
Source: January 2013 review of
GymPact on iMedicalApps
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Biases are not independent and can be present
throughout the decision making process
Access
Framing effects
cloud
consumers’
preferences
Demand
Wellinformed,
rational
consumers
reward
best-value
firms
Assess
Inertia limits the
extent of search
Lack of
knowledge
limits available
options
Hyperbolic
discounting
leads to timeinconsistent
preferences
Consumers
resort to
heuristics when
faced with too
many options
Act
Supply
Consumers
over-estimate
their abilities,
motivation, and
knowledge
Inertia limits
switching
Firms are
incentivized
to deliver
what the
consumers
want
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Case study: Drip pricing
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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)
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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
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The market may or may not correct for this
  Behavioral economics are a new tool in the competition economist’s
toolkit
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Enhance existing tools, not replace them
Understanding homo sapiens rather than homo economicus will allow us to
better champion competition
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Live long and prosper
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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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