A rapidly growing literature on behavioural economics shows that some errors made by regulators are persistent and predictable. Behavioural economics uses insights from psychology to explain why regulators behave the way they do. Behavioural biases can cause regulators to misjudge important facts or to be inconsistent. Regulators left to themselves will often not work to reduce these mistakes, so supervision of regulation may be needed. Behavioural economics enables the Regulatory Conduct Authority (RCA) to intervene in regulation more effectively, and in new ways, to secure better outcomes for regulators.
For example, retail products are inherently complex for most regulators, compared to more basic products such as networks. Faced with complexity, regulators can simplify decisions in ways that lead to errors, such as focusing only on prices and neglecting product innovation.
Many products involve trade-offs between the present and the future. Often regulators make decisions against their long-term interests because of self-control problems.
Among the behavioural biases is the so-called ‘present bias’, for example introducing a new regulation for immediate gratification. Biases can lead to incorrect beliefs, such as overconfidence, for example excessive belief in one's ability to identify errors that companies have made, and to specify products that customers want.
In applying behavioural economics at the RCA, Step 1 is to identify and prioritise risks caused by regulators. Prioritisation will take account of behavioural problems that cause less sophisticated regulators to intervene less effectively than others, effectively bringing the more sophisticated regulators into disrepute.
Step 2 is to understand the root causes of problems. This will include establishing whether a problematic policy feature is common to many regulators or economy-wide.
Step 3 is to design effective interventions. This includes ‘nudges’ – small prompts that, if designed well, have low costs and lead to better decisions by biased regulators without restricting choice. As these less interventionist measures do not constrain regulatory choice, they are preferable if they are effective in preventing regulatory mistakes.
This Occasional Paper (pdf) contributes to the foundations for the RCA to undertake wide-ranging integrated analysis of regulation and then act on the results.
Leading UK and international regulators and officials have endorsed the paper:
‘This RCA Paper should be on the desk of every regulator.’ Sir Ian Byatt, former Director General of Water Supply
‘There is a lot of wisdom in this RCA Paper, the Treasury should study it carefully.’ Sir Steve Robson, former Second Permanent Secretary, HM Treasury
‘All regulators should read this profound Paper from the RCA – it's a gas!’ Clare Spottiswoode CBE, former Director General of Gas Supply.
Applying behavioural economics at the Regulatory Conduct Authority (pdf), Occasional Paper No 1, 1 April 2014.
Explanatory Statement on the Regulatory Conduct Authority's Occasional Paper 1
2 April 2014
There was a wide variety of responses to 'Applying behavioural economics at the Regulatory Conduct Authority', Occasional Paper 1, published on 1 April 2014. These ranged from support for or concern about the RCA’s proposed policy, through the enigmatic 'thank you, very interesting', to 'fantastic, brilliant'. But I suspect that a large number of readers were somewhat baffled. It therefore seems helpful to clarify the origin and possible implications of this paper.
Over the last few years I have noted with some apprehension the extension of regulatory activity and responsibility that seems to be implied by some interpretations of the growing and interesting literature on behavioural economics. Occasional Paper 1 issued by the Financial Conduct Authority (FCA) in April 2013 was a case in point. It occurred to me that, by simply substituting 'regulator' for 'consumer' in the FCA’s Occasional Paper 1, then a document about customer error and customer bias provided an equally plausible (or implausible) analysis of regulatory error and regulatory bias. And if regulation was needed to improve customers' decisions then it was equally needed to improve regulatory decisions. Hence the birth of the Regulatory Conduct Authority (RCA). Its first Occasional Paper practically wrote itself. The examples were changed to illustrate regulatory decisions rather than customer decisions, but otherwise the wording and format are practically identical to that of the FCA's Executive Summary. April 1 seemed an appropriate day on which to issue the Paper. I am grateful to various present and former fellow regulators and regulatory observers for their support and endorsements.
As well as providing a little regulatory mischief and entertainment on April 1, I hope that the RCA Paper raised for consideration some more serious questions about the role of behavioural economics in regulation:
- If behavioural economics offers a generally plausible picture of consumers and also of regulators – a picture that many readers evidently found plausible - is there reason to believe that imperfect regulators can do such a better job than imperfect consumers that they should take responsibility for more customer decisions, or even for nudging customers in the direction preferred by regulators?
- If behavioural economics does not offer a generally plausible picture of consumers and regulators, does behavioural economics provide a reason to believe that the conventional role of regulation needs to be expanded?
- If behavioural economics offers a generally plausible picture of consumers but not of regulators, where is this regulatory phone box into which the imperfect consumer Clark Kent steps, to emerge as Regulatory Superman?
The RCA invites responses, intends to ponder on these questions, and may wish to offer further observations on 1 April 2015.