A recent post on this blog referred to what sounds a fascinating new book, What Money Can’t Buy: The Moral Limits Of Markets, by Michael Sandel. The Guardian also recently featured an extract from this book.
As the earlier blog post discussed, our lives are now dominated by markets. Economists typically believe markets are the best way to allocate resources as, if the market mechanism works correctly, the resulting equilibrium maximizes economic welfare as measured by the sum of consumer and producer surplus. In particular, all consumers that are willing to pay a price above the market price are able to buy the product.
Fundamental to the measurement of consumer welfare is the notion that consumers will be prepared to buy a product as long as their willingness to pay exceeds the price. It therefore follows that consumers are more likely to buy the product as the price falls and, if they do so, gain increasing surplus. However, the extract from Michael Sandel’s book provides a number of interesting examples which suggest that in some situations this might not be the case.
One example concerns the storage of nuclear waste in Switzerland. When surveyed, 51% of the residents of the small Swiss village of Wolfenschiessen, said that they would be prepared to accept the waste being stored nearby. However, somewhat surprisingly, this figure fell to 25% when the residents were told that they would be compensated for the inconvenience. Furthermore, the figure remained at this low level even when the proposed compensation was increased to over £5000 per person.
Sandel argues that this is because, once compensation is introduced, financial incentives crowd out public spirit. He suggests that:
putting a price on the good things in life can corrupt them.
For economists, this potentially has important implications for how we evaluate market outcomes and our belief that the market equilibrium is always the optimal outcome. Furthermore, it suggests that in some circumstances allowing the market mechanism to allocate resources may not be the ideal solution.
What money can’t buy – review The Guardian, John Lanchester (17/05/12)
Michael Sandel: ‘We need to reason about how to value our bodies, human dignity, teaching and learning’ The Guardian, Decca Aitkenhead (27/5/12)
We must decide on the way we want to live now London Evening Standard, Matthew d’Ancona (23/05/12)
- How is consumer surplus calculated?
- How does the market mechanism allocate resources?
- How would you explain the responses of the residents in the Swiss village?
- Do you think the Swiss residents would respond in the same way if the compensation offered was increased even further?
- What type of products and services do you think might be less well suited to being provided by markets?
Next year a government agreement with insurance companies is set to end. This agreement requires insurance companies to provide cover for homes at a high risk of flooding.
However, in June 2013, this agreement will no longer be in place and this has led to mounting concerns that it will leave thousands of home-owners with the inability either to find or afford home insurance.
The key thing with insurance is that in order for it to be provided privately, certain conditions must hold. The probability of the event occurring must be less than 1 – insurance companies will not insure against certainty. The probability of the event must be known on aggregate to allow insurance companies to calculate premiums. Probabilities must be independent – if one person makes a claim, it should not increase the likelihood of others making claims.
Finally, there should be no adverse selection or moral hazard, both of which derive from asymmetric information. The former occurs where the person taking out the insurance can hide information from the company (i.e. that they are a bad risk) and the latter occurs when the person taking out insurance changes their behaviour once they are insured. Only if these conditions hold or there are easy solutions will the private market provide insurance.
On the demand-side, consumers must be willing to pay for insurance, which provides them with protection against certain contingencies: in this case against the cost of flood damage. Given the choice, rational consumers will only take out an insurance policy if they believe that the value they get from the certainty of knowing they are covered exceeds the cost of paying the insurance premium. However, if the private market fails to offer insurance, because of failures on the supply-side, there will be major gaps in coverage.
Furthermore, even if insurance policies are offered to those at most risk of flooding, the premiums charged by the insurance companies must be high enough to cover the cost of flood damage. For some homeowners, these premiums may be unaffordable, again leading to gaps in coverage.
In light of the agreement coming to an end next year, there is pressure on the government firstly to ensure that insurance cover is available to everyone at affordable prices and secondly to continue to build up flood defences in the most affected areas. Not an easy task given the budget cuts. The following articles provide some of the coverage of the problems of insuring against flood damage.
200,000 homes ‘at flooding risk’ BBC News (3/1/12)
MPs slam government flood defences Post Online, Chris Wheal (31/1/12)
Flooding: 200,000 houses at risk of being uninsurable The Telegraph (31/1/12)
Flood defences hit by government cuts ‘mismatch’, says MP Guardian, Damian Carrington (31/1/12)
Fears over cash for flood defences The Press Association (31/1/12)
ABI refuses to renew statement of principles for flood insurance Insurance Age, Emmanuel Kenning (31/1/12)
- Consider the market for insurance against flood damage. Are risks less than one? Explain your answer
- Explain whether or not the risk of flooding is independent.
- Are the problems of moral hazard and adverse selection relevant in the case of home insurance against flood damage?
- If ABI doesn’t put in place another agreement to provide insurance to homeowners at most risk of flooding, what could be the adverse economic consequences?
- Is there an argument for the government stepping in to provide insurance itself?
- Explain why insurance premiums are so much higher for those at most risk of flooding. Is it equitable?
When people shop in supermarkets they often look for what’s on special offer. After all, everyone likes a bargain. About 35–37% of supermarket items are on special offer at any one time and around 50% of the money spent by customers is on such items.
But things aren’t always as they seem. Supermarkets use clever marketing to persuade people that they’re getting a good deal, while sometimes it’s nothing of the sort. Examples include putting up prices for a while and then reducing them again saying “huge reduction”; or promoting an offer of, say, “three for £2”, when you could buy an individual item for 60p; or using the word “now” £2.50 to imply that the previous price was higher, when in fact it wasn’t; or selling a double-sized “value pack” for more than double the price of the regular size. These tricks are commonplace in supermarkets.
Sometimes the wary consumer will be able to find out which offers are genuine, but it’s not always that easy. And even if you do buy something at a genuine discount, is it something you really want? Or have you been persuaded to buy it simply because it’s on offer? Supermarkets study consumers’ psychology. They find clever ways of promoting products to make us feel that we have done well in getting a bargain.
The following programme in the BBC’s Panorama series looks at the big four supermarkets in the UK – Tesco, Asda, Sainsbury’s and Morrisons – which between then have 68% of supermarket sales. It gives examples of some of the not so special offers and how consumers are being hoodwinked.
Revealed: The truth about supermarket ‘bargains’ BBC Panorama (clip), Sophie Raworth (5/12/11)
The Truth About Supermarket Price Wars BBC Panorama (full programme), Sophie Raworth (5/12/11)
What you need to know about the supermarket price wars Totally Money (7/12/11)
Supermarkets accused of misleading consumers The Telegraph, Nick Collins (5/12/11)
Supermarket price war: Can they all be cheapest? BBC News, Anthony Reuben (9/12/11)
Are Our Retailers Criminals? International Supermarket News, Laura Elliott (6/12/11)
Supermarket deals “not what they seem” warns expert Retail Gazette, Gemma Taylor (6/12/11)
- What types of misleading offers are identified in the Panorama report?
- For what reasons are consumers “taken in” by such offers? Does this imply that consumers are irrational?
- Does intense oligopolistic competition between the big four supermarkets lead to lower prices?
- How is it possible for two supermarkets to claim that they are cheaper than the other? How would you decide which supermarket was generally cheaper?
- Why might it be difficult for an independent agency to do a comparison of prices of different supermarket chains?
Most people are risk-averse: we like certainty and are generally prepared to pay a premium for it. The reason is that certainty gives us positive marginal utility and so as long as the price of insurance (which gives us certainty) is less than the price we place on certainty, we will be willing to pay a positive premium. By having insurance, we know that should the unexpected happen, someone else will cover the risk. As long as there are some risk-averse people, there will always be a demand for insurance.
However, will private companies will be willing to supply it? For private market insurance to be efficient, 5 conditions must hold:
1. Probabilities must be independent
2. Probabilities must be less than one
3. Probabilities must be known or estimable
4. There must be no adverse selection
5. There must be no moral hazard
If these conditions hold or if there are simple solutions, then insurance companies will be willing and able to provide insurance at a price consumers are willing to pay.
There are many markets where we take out insurance – some of them where insurance is compulsory, including home and car insurance. However, one type of insurance that is not compulsory is that for cyclists. No insurance is needed to cycle on the road, but with cycle use increasing and with that the number of accidents involving cyclists also increasing, the calls for cyclists to have some type of insurance is growing. If they are hit by someone without insurance and perhaps suffer from a loss of income; or if they cause vehicle damage, they will receive no compensation. However, whilst the risk of accident is increasing for cyclists, they are still statistically less likely to cause an accident than motorists. Perhaps a mere £30 or £40 per year for a policy is a price worth paying to give cyclists certainty. At least, this is what the Association of British Insurers (ABI) is claiming – hardly surprising when their members made a combined loss of £1.2 billion!
Cyclists ‘urged to get insurance’ BBC News, Maleen Saeed (26/11/11)
Cyclists urged to get more insurance by … insurance companies Road.CC, Tony Farrelly (26/11/11)
The future of cycle insurance Environmental Transport Assocaition (24/11/11)
- With each of the above conditions required for private insurance to be possible, explain why each must hold.
- What do we mean by no moral hazard and no adverse selection? Why would their existence prevent a private company from providing insurance?
- Using the concept of marginal utility theory, explain why there is a positive demand insurance.
- What might explain why cyclists are less likely to take out insurance given your answer to the above question?
- Do you think cyclist insurance should be compulsory? If governments are trying to encourage more sustainable transport policy, do you think this is a viable policy?
In 2009, Nudge: Improving Decisions about Health, Wealth, and Happiness was published. This book by Richard Thaler and Cass R. Sunstein examines how people are influenced to make decisions or change behaviour.
According to Thaler and Sunstein, people can be ‘nudged’ to change their behaviour. For example, healthy food can be placed in a prominent position in a supermarket or healthy snacks at the checkout. Often it is the junk foods that are displayed prominently and unhealthy, but tasty, snacks are found by the checkout. If fashion houses ceased to use ultra thin models, it could reduce the incentive for many girls to under-eat. If kids at school are given stars or smiley faces for turning off lights or picking up litter, they might be more inclined to do so.
The UK government has been investigating the use of ‘nudges’ as a way of changing behaviour, and the House of Lords Science and Technology Committee has been considering the question. It has just published its report, Behaviour Change. The summary of the report states that:
The currently influential book Nudge by Richard Thaler and Cass Sunstein advocates a range of non-regulatory interventions that seek to influence behaviour by altering the context or environment in which people choose, and seek to influence behaviour in ways which people often do not notice. This approach differs from more traditional government attempts to change behaviour, which have either used regulatory interventions or relied on overt persuasion.
The current Government have taken a considerable interest in the use of “nudge interventions”. Consequently, one aim of this inquiry was to assess the evidence-base for the effectiveness of “nudges”. However, we also examined evidence for the effectiveness of other types of policy intervention, regulatory and non-regulatory, and asked whether the Government make good use of the full range of available evidence when seeking to change behaviour.
The report finds that nudges
… used in isolation will often not be effective in changing the behaviour of the population. Instead, a whole range of measures – including some regulatory measures – will be needed to change behaviour in a way that will make a real difference to society’s biggest problems.
So is there, nevertheless, a role for nudges in changing behaviour – albeit alongside other measures? Read the report and the articles below to find out!
Lords report calls for regulation over persuasion to improve public health Wales Online, David Williamson (19/7/11)
Government’s ‘nudge’ approach to health is not enough, according to House of Lords and Work Foundation HR Magazine, David Woods (20/7/11)
How can I tell if I’ve been nudged Independent, Natalie Haynes (20/7/11)
Healthier behaviour plans are nudge in the wrong direction, say peers Guardian, Sarah Boseley (19/7/11)
‘Nudge’ is not enough, it’s true. But we already knew that Guardian, Jonathan Rowson (19/7/11)
Nudge not enough to change lifestyles – peers BBC News, Nick Triggle (19/7/11)
Why a nudge is not enough to change behaviour BBC News, Baroness Julia Neuberger (19/7/11)
House of Lords findings: why green Nudges are not enough The Green Living Blog, Baroness Julia Neuberger (19/7/11)
Lords Science and Technology Sub-Committee publish report on Behaviour Change YouTube, Baroness Julia Neuberger (14/7/11)
Press Release Lords Science and Technology Select Committee (19/7/11)
Behaviour Change Lords Science and Technology Select Committee (online version) (19/7/11)
Behaviour Change Lords Science and Technology Select Committee (PDF version) (19/7/11)
- When may a nudge (a) be enough, (b) not be enough to change behaviour?
- What instruments does the government have to change behaviour?
- Distinguish between a ‘technical’ and an ‘adaptive’ solution to changing behaviour. Give examples.
- Why might adaptive solutions provide more of a challenge to policymakers than technical solutions.
- Can a nudge ever be transformative?