Behavioural economics: theory and data
Behavioural economics combines the normative backbone of economics with insights from the behavioural sciences (Kahneman, 2011). This combination allows situations to be identified in which consumers and decision makers in general deviate from the economic benchmark of rational behaviour. To discuss a bias or deviation, we first need to define what determines a benchmark of rational behaviour. Such a discussion will also explain where the traditional economic argument that governs current financial services regulation comes from.
Basic economic theory considers choices as rational if they can be shown to fulfil a set of basic assumptions. While authors vary on the exact composition of this set and the specificity, usually the set includes: completeness and transitivity.
Completeness simply says that consumers are able to make a choice between any pair of products offered to them. Transitivity requires a consistency of choice, i.e., if one option is preferred over another, then whatever other options are added, this relationship remains. Economic models may be more specific in their characterization of optimal behaviour of individuals. But in almost all cases they assume that (optimal) choices of decision makers need to be complete and transitive to be called rational.
Gilboa (2010, p. 5) is one of the few authors with a less demanding definition of rational behaviour. In his view behaviour “is rational for a given person [the decision maker] if this person feels comfortable with it, and is not embarrassed by it, even when it is analysed for him [or her]”. This definition is helpful as it is evident — and can be shown empirically - that simple choices with assumptions such as completeness and transitivity are the determinants of ‘comfort’ or‘non-embarrassment’ of decisions that we try to justify to ourselves or others.
In law, the concept of rationality has a close counterpart in the concept of a reasonable person. While a reasonable person may not have the capacity to understand and analyse all the information provided, he or she is expected to use all the information that is provided to him or her reasonably. Both the rational and the reasonable decision maker will not be confused by overprovision of information or by the use of unusual concepts.
For many choices, rational or reasonable behaviour would seem to be an acceptable point of comparison for a “good” decision. Simple choices such as choosing between apples and peaches for an afternoon snack, or between a family holiday and a new TV, fall into this category. However, many financial products present a far more involved choice. Financial products do, nevertheless, have one advantage. Some characteristics of these products are easily comparable as they can be represented in monetary terms. The decision is thus cast in the simple terms of “more is better than less”.That is, people prefer to have as much money as possible.
Traditional theory of regulation assumes that rationality applies to these decisions as well. But here the definitions lead to different interpretations of rationality'. A fundamental assumption-based definition will claim that, as long as individuals have all the information, they' must make a rational or reasonable choice. Whereas a rational individual in the sense of Gilboa’s definition will say he is comfortable with many choices given the fine print is too much for him or her to have considered in making the choice at hand.
When data relating to financial decisions are examined we ask questions about choices made by consumers and try to benchmark them against optimal choices. While this may be difficult with more complex financial products — for example superannuation funds or hybrid securities - it may be more straightforward in the case of simpler products, such as credit cards or simple saving accounts. We will look for cases where simple dominance relationships between financial product offerings can be found in a category. That is, situations are sought where the returns and benefits are at least as good for one option compared to the other and the costs of this option are lower. Most consumers, when the two options are properly explained, would use the low cost/same or higher benefits option over the alternative option. If we observe choices to the opposite, we will see this as confusion or underperformance. Note that we define confusion in this case as choices that cannot be rationalized easily. We do not necessarily identify the reasons for these choices. In two of our three concepts proposed, the measures can be complemented with instruments to identify reasons for these decisions.
These approaches do not consider whether consumers are able to identify specific characteristics of products. Are consumers able to correctly understand product information provided? To provide a simple illustration of the case not covered by the proposed approaches, consider the 2011 floods in Queensland, Australia. Many consumers were caught out by not being aware of the difference between inundation - water rising from below — and floods - water rushing through a property. While many affected residents were not covered for inundation, they were for floods. For most people, however, these two phenomena were essentially the same. In other words, what is referred to as the Brisbane flood, was largely an inundation event, against which the majority of consumers were not insured. This type of confusion is not covered by the present proposals.
-  Any microeconomic textbook can provide an overview of these assumptions or axioms — theterminology academic economists use for these. See, for example, Varian (2014), Mas-Colell,Whinston, and Green (1995) or Bowles (2009).
-  For a discussion of these two concepts and their relationship, see Sibley (1953).
-  For a growing literature that discusses judgement errors of individuals in the context of law andregulations, see, e.g., Sunstein (2000) andjolls (2007).