In late 2022, BETA and the ACCC presented at the Public Sector Economist Conference in Canberra on the application of behavioural economics (BE) in regulation. The presentation built on Raj Chetty’s implications of BE for public policy to outline three ways in which BE can benefit regulation.
Behavioural economics provides:
- An additional set of criteria to help identify when regulation can benefit society
- A set of tools that offer an expanded range of potential outcomes, and
- An improved understanding of human behaviour and the impacts of firms’ efforts to guide behaviour.
What this means for regulatory design and enforcement:
Rationale for Regulation
Standard economics focuses on market failures as a reason for regulation – market power, public goods, externalities or information asymmetries. BE demonstrates that regulation can also provide a net benefit to society in other situations when behavioural biases are leading to a significant reduction in societal welfare.
An example of this is add-on insurance - the insurance you’re sometimes offered alongside another purchase, like travel insurance when you book a flight or an extended warranty when you buy a TV. In 2019, the Government announced it would introduce new regulation in the add-on insurance market, even though there was arguably no traditional market failure. It was clear, however, that many of these insurance products offered poor value to consumers with some offering payouts of less than 10% of the premiums paid (compared to more than 80% for typical car and home insurance products).
When BETA conducted research in 2020 to inform the regulatory design, we found many consumers purchased add-on insurance due to behavioural factors like loss aversion and mental fatigue. The products were often sold using high-pressure tactics and were typically not well understood by consumers. Behavioural economics, in this case, offered a clear rationale for the government to regulate. The poor consumer outcomes and the existence of behavioural biases suggested that regulation could improve consumer welfare, even though there was no traditional market failure.
In 2021, the Government introduced a deferred sales model that requires sellers to wait four days between the sale of the primary product and the sale of the insurance, to take the heat out of the pressure sales tactics. Sellers were also required to provide an information sheet to help inform consumers about their decision. BETA worked with ASIC to design and test behaviourally-informed prototypes of these information statements to inform regulations. Our most effective information statements led to a 24% reduction in add-on insurance purchases compared to a control group in our simulation.
In this example, behavioural economics provided the rationale for regulation, and the solution combined traditional regulatory tools and behavioural design.
A bigger toolkit
BE offers a range of policy tools, including nudges, to help regulators design regulation, support compliance and reduce compliance costs. Mostly these behavioural tools work by changing the choice architecture that people face, and offer an expanded set of potential outcomes. A nudge like a default selection on a form, for example, will influence those experiencing behavioural biases without restricting the choices of decision-makers who are paying closer attention. Behavioural tools can also be combined with traditional policy tools. For example, behaviourally informed financial incentives—that is incentives where the timing, nature, or perception of the incentives is informed by the behavioural literature—can outperform standard incentives.
Sometimes behavioural tools can achieve a similar impact to traditional policy tools but with lower compliance costs. As a result, behavioural tools can sometimes offer a higher net benefit to society than traditional tools.
A good example is BETA’s work with the Fair Work Ombudsman to improve compliance among employers in paying award wages. We applied behavioural tools to the FWO’s audit process, using simplification, salience, social norms and reminders. To test these changes, we ran a randomised controlled trial with 1800 small businesses. The enhanced audits decreased non-compliance (from around 20% to around 15%), reduced complexity and compliance costs for the businesses involved and reduced the length of the audit (by 8 days or 35 percent). It was a win-win. The behavioural tools improved outcomes for both businesses and workers.
In this example, BE applied a set of tools to regulatory enforcement and improved compliance while reducing compliance costs.
A better understanding of human behaviour
The final element of the framework is the most important—an improved understanding of consumers’ behaviour and the impacts on consumers of firms’ actions. This element helps inform the first two, and is helpful at all stages of the regulatory policy process. It can help regulators understand the drivers of poor outcomes, anticipate how consumers will react to regulation or to firms’ efforts to guide behaviour (such as ‘sludge’ or ‘dark patterns’), and design remedies to improve outcomes.
A key driver of our improved understanding of behaviour is BE’s culture of careful evidence gathering—which brings an inductive mindset that complements the more deductive culture of standard economics.
A good example of this is BETA’s 2020 project on Online Wagering. BE tells us that gamblers are prone to behavioural biases, such as the selective recall of wins. This rich understanding of human behaviour allowed us to design activity statements that aimed to correct these biases. We ran a randomised controlled trial where over 1500 participants participated in a simulated gambling platform, to test the impact of activity statements. Our most effective activity statement led to gamblers betting almost 8% less over the course of the simulated gambling session.
BETA’s online wagering research, drawing on a better understanding of human behaviour, helped inform both the rationale for and the design features of new regulation introduced by States and Territories in July 2022.
BE can also help regulators understand the impacts of firms’ efforts to guide behaviour. When firms use consumers’ behavioural biases against them to make a good decision more difficult, this is often called ‘sludge’. For example, some firms create friction for consumers trying to cancel a subscription. BE’s evidence-based understanding of human behaviour can assist regulators in identifying sludge and forecast the likely impacts on consumer outcomes.
What does this mean for policymakers and regulators?
The examples we’ve discussed in this blog demonstrate the enormous value that BE can bring to regulation. Here in BETA, we’d love to see all regulatory policy design and enforcement use a behavioural lens alongside traditional approaches. Specifically, we encourage policymakers and regulators to:
- Gather evidence on consumer outcomes and behaviour in markets and take them into account when weighing up the rationale for regulation
- Aim to understand what’s driving behaviour (including of consumers and regulated entities)—this can guide regulation or non-regulatory solutions like improved processes and messaging
- Consider applying behavioural interventions (nudges, behavioural design) to complement or inform traditional regulation
- Test solutions rigorously wherever possible—BE tells us that humans don’t always react the way we expect and it’s important to carefully test solutions in each new context
Behavioural economics can be a powerful complement to traditional policy frameworks in regulation. We hope you can find opportunities to apply it in your work.
Here’s some further reading on BE and regulation if you’re keen:
Barr, Michael S., Sendhil Mullainathan, and Eldar Shafir. "Behaviorally informed regulation." (2012).
Chetty, Raj. "Behavioral economics and public policy: A pragmatic perspective." American Economic Review 105, no. 5 (2015): 1-33.
Congdon, William J., Jeffrey R. Kling, and Sendhil Mullainathan. Policy and choice: Public finance through the lens of behavioral economics. Brookings Institution Press, 2011.
Madrian, Brigitte C. "Applying insights from behavioral economics to policy design." Annu. Rev. Econ. 6, no. 1 (2014): 663-688.