Are companies forced to exploit our biases?

Cass Sunstein pens an interesting article on Behavioral Economics and Consumer Protection. This part on the competitive forces of market competition encouraging companies to exploit our biases is worth thinking about.

Oren Bar-Gill has a straightforward answer to the critics. He believes that government regulation can be justified by “behavioral market failures,” in the form of biases and misperceptions that have been carefully studied in psychology and behavioral economics. Bar-Gill does not refer to the gorilla experiment, but he places a lot of emphasis on salience, and he contends that because consumers are imperfectly rational, they are likely to ignore important information and hence to make big mistakes. To be sure, he acknowledges that, in principle, competition could correct the problem. But he insists that, in practice, competitive forces are often the problem, not the solution. The reason is that sellers must do what the market rewards. If sellers offer people the objectively best cell phone contracts, they will end up losing out to their competitors, who are offering contracts that are less good but subjectively more appealing.

To be clear, Bar-Gill does not contend that there is literal fraud here, but urges instead that as a result of competitive pressures, sellers are forced “to exploit the biases and misperceptions of their customers.” In his view, the consequences for consumers can be extremely bad. Indeed, “seductive” contract design helped fuel the demand for subprime mortgages, thus contributing to the subprime meltdown of 2008. But how, exactly, do companies exploit these biases and misperceptions? Bar-Gill emphasizes two strategies. The first involves cost deferral. The second involves complexity.

How does this manifest itself? – (Cost deferral)

In consumer contracts, you can often find agreements whose terms look tantalizingly favorable in the short-term, but a lot less favorable in the long-term. For credit cards, you might get short-term teaser interest rates that would cost you very little, but after a while, you might end up with long-term fees and rates that would cost you a lot. (A recent illustration from a website for a highly reputable issuer: “0% Intro APR on balance transfers for the first 15 months after account opening. After that a variable APR currently 15.99% or 24.99% depending on your creditworthiness.”) For cell phone contracts, you might get a free phone, which to some people sounds pretty appealing, even amazing—but you get the phone only if you sign a two-year lock-in contract, which contains an assortment of fees and penalties.

This works for multiple reasons, including our bias on the short term and our ability to ignore the base rates (that is, we underestimate the actual odds that something unfavourable will happen to us).

Another strategy is complexity (see also, Manufactured Uncertainty)

Bar-Gill notes that with respect to credit cards, mortgages, and cell phones, the underlying agreements are staggeringly complex. Why are there so many confusing and disparate terms? Bar-Gill contends that from the standpoint of sellers, complexity has a big virtue, which is that it prevents consumers from easily figuring out the total cost of the relevant products. As a result, consumers must rely on what is salient. And if some terms are salient while others are not, sellers will have real opportunities to make money, and consumers will make big mistakes.