Summary:
– The introduction of a rating system would guarantee the quality of goods and services offered to consumers with limited information.
– Ex-post regulation would focus on easing the conditions for groups of consumers to take legal action more often.
Classical microeconomic theory is based on the assumption of pure and perfect rationality on the part of individuals who maximize their well-being by minimizing their costs and having perfect and transparent information at all times. In reality, these conditions are difficult to achieve: in order to maximize their profits, producers often have an interest in making consumers irrational in order to make their products more attractive. This led to a very interesting report by the Economic Analysis Council in September 2012 (source: « Consumer protection: limited rationality and regulation« ): should consumers be protected to prevent producers from taking advantage of their limited rationality, and if so, in what cases and how?
The risk of regulator capture
Regulation is necessary to correct market imperfections, but it requires defining at what point the state (or any public body) should intervene between producers and consumers. Among the risks of overly strict regulation are, for example, (1) the risk of consumers becoming less responsible, as they become « at risk » as soon as an activity is no longer regulated, (2) the risk of corruption among regulators (lobbying, interest groups) (3) the fact that regulators themselves are not always able to judge situations perfectly and make the best decisions at all times. To correct this problem, we would then have to regulate the regulators… and therefore regulate those who regulate the regulators! This little reductio ad absurdum argument is a first demonstration of the futility and ineffectiveness of total regulation of the economy.
A sentence from the CAE report sums this up perfectly: « Ultimately, paternalism leads to a strengthening of the power of regulators, from whom it is illusory to expect unconditional benevolence. Regulators are neither angels nor demons, but teams of human beings pursuing their own interests. In particular, regulators can be partly captured by the companies they regulate. »
Take, for example, a highly complex financial product offered by a bank that will try to exploit consumers’ limited rationality to maximize its profits. According to microeconomic theory, agents are able to clearly assess the performance and risks of this financial product and then compare it with others in order to make the best choice. Let’s assume that the bank has fulfilled its duty to provide information and that everything is clearly detailed in a contract running to dozens of pages. Should the marketing of this highly complex product still be regulated?
We can assume that consumers are sufficiently informed that the regulator does not need to intervene. If the financial product performs below customer expectations, the bank’s reputation risk would increase. The market would adjust itself; this is the invisible hand of the market. But in practice, many companies think in the short term.
Proposals for ex-ante and ex-post regulation for consumers
Managers seek to maximize the company’s profits over a year in order to earn their bonuses, rather than thinking long term. Furthermore, this automatic correction by the market assumes that consumers can easily find out what other consumers think about the quality of a product, and that this information is not biased (false evaluations or biased exchanges between consumers). Among the six proposals made by the three economists in the report « Consumer Protection: Limited Rationality and Regulation, » one attempts to address this issue without necessarily resorting to excessive regulation:
The Directorate-General for Competition, Consumer Affairs, and Fraud Control (DGCCRF) or the National Consumer Institute become administrators of an online rating platform based on technologies similar to those used by large online retailers.
Customers can write a brief comment and give a rating reflecting their consumer experience of each specific product or service: (1) access to this rating database will be free of charge, and keyword searches (product or service provider name) will be possible (2) customers must enter their personal data for their comments to be valid (but this data will not, of course, be made public) (3) the DGCCRF would, in its capacity as administrator, have the right to filter or remove comments deemed irrelevant; and (4) when entering a comment, customers can tick a specific box to make their comment an official complaint (the website then redirects them to a web page that collects supporting documents and personal data to validate the complaint).
These innovative methods could improve the information available to consumers to help them make more rational decisions, without creating a new large independent regulatory authority that would act ex ante rather than ex post. There are two types of regulation: ex ante regulation and ex post regulation. Ex-ante regulation refers to all measures aimed at regulating the relationship between the producer and the customer before the purchase or before the marketing of a product (certifications, legal obligations). Ex-post regulation concerns the possibilities of recourse for the consumer after the purchase of a product, for example in the event of fraud or if the customer is dissatisfied with the product.
One example of an ex-post proposal put forward in the report is the possibility for consumers to exert real power to deter illegal behavior by strengthening penalties and facilitating class actions. For example, consumers are unlikely to take legal action as soon as a product offered by a bank yields a lower return than expected. However, if it were possible to easily join forces with other consumers to bring a collective class action lawsuit, recourse to legal proceedings would become more common. Such a procedure, by aggregating individual damages, would become significant enough to serve as a real deterrent.
Conclusion:
Consumers are indeed « naive, » to use the terms of the CAE report. A « naive » consumer is unable to recognize their bias toward the present and cannot assess the unidentified costs underlying a consumer action (e.g., commitments, fees, and penalties on banking products).
There are two ways to make consumers less naive: (1) « educate » and provide more information to consumers, using new information technologies, or (2) increase regulation and control the sale of products.
References:
Xavier Gabaix, Augustin Landier, and David Thesmar: « Consumer protection: limited rationality and regulation, » Economic Analysis Council, September 11, 2012.
