Economics focus

The aggro of the agora
Jan 12th 2006
From The Economist print edition

Consumers fail to measure up to economists' expectations

“WE MUST accept the consumer as the final judge,” wrote Frank Taussig, a former president of the American Economic Association (AEA), in 1912. His view was once an article of faith of the economics profession: the consumer was sovereign, the market his servant. It fell to economists only to explain the consumer's decisions, not to second-guess them.

The AEA's latest annual meeting, held last weekend, made one thing abundantly clear: this ritual deference to consumer sovereignty is slipping. Among the opening sessions was one entitled “The economics of paying too much”, a rich genre that spans gym memberships, banking fees and inkjet cartridges. The next day, John Campbell, president of the American Finance Association (AFA), dwelt on the failure of households to hold enough shares, diversify their assets fully or refinance their mortgages promptly. Meanwhile, Daniel McFadden, the AEA president, argued that the unshackling of markets, which has proceeded apace since the 1980s, would fall short of its promise if consumers were not similarly freed from the fetters of ignorance, self-deception and intemperance.

Mr McFadden's speech leaned on the work of neuroeconomists, who claim to prove what Adam Smith long ago asserted: man's “propensity to truck, barter and exchange” runs deep in our nature. According to brain scans, it lurks in the same primitive, limbic vaults of the cerebrum as our instinct to fight, flee and feed ourselves. Indeed, “shopping and sex share the same neurotransmitters and receptors,” Mr McFadden jokes.

But if trading turns some people on, it puts others off. Markets can be “rough, murky, tumultuous places”. Consumers may doubt themselves, the products on display and the people flogging them. Losing out—paying too much—is an ever-present danger. This can be character-building, of course. By punishing a consumer's mistakes and inconsistencies, the market may whip him into shape, so that he more closely resembles the rational actor an efficient market deserves. But Mr McFadden worries that consumers may instead develop an aversion to markets: “Opportunities for choice may be interpreted as opportunities for mistakes, embarrassment and regret.” He calls this agoraphobia. In common parlance, this is a fear of open spaces; translated literally from Greek, it means “fear of the marketplace”.

In his class at the University of California, Berkeley, Mr McFadden randomly handed out pencils, embossed with the course's name, to half of his 345 students. He then held a sealed-bid auction, designed so that no one had any reason to lie about how much a pencil was worth to them. Since the pencils were distributed at random, there was no reason to think pencil-owners should be any more eager to hold on to their pencils than bidders were to buy them. Whatever value the median student places on a pencil, about half the pencil-holders should value them less, and half of those without pencils should value them more. Thus 86 pencils should change hands.

In fact, only 32 pencils were traded. This might be the result of what economists call the “endowment effect”: we value what we own more highly, simply because we own it. But Mr McFadden reckons that another explanation is also at work. Even for something as trivial as a pencil, fear of overpaying or selling too cheaply inhibits trade: “Consumers find trade an edgy experience...and resist trading for small gains.”

This reluctance to face the market may also apply to much weightier matters. Listening to Mr Campbell's AFA address, it is easy to conclude that agoraphobia reigns over the American housing market. Most American mortgages offer fixed interest rates, but can be refinanced without penalty should the household so wish. The steep decline in interest rates between 2001 and 2003 prompted many households to do just that. But a large fraction fell victim to inertia. In 2003, Mr Campbell estimates, most households were still paying interest at more than a percentage point above the market rate; an eighth were paying a spread of more than three points.

Financial flossing

What to do? Mr Campbell is inspired by the example of dentistry. The big gains in oral health, he points out, stemmed from straightforward advice and easy-to-use products. Economists should promote the financial equivalent of brushing twice daily with toothpaste. Such simple, effective ideas are surprisingly rare in an otherwise competitive financial industry. Why, for example, does a mortgage lender not offer a fixed-rate mortgage that refinances automatically whenever the market rate falls too far below the rate the customer is paying?

Mr Campbell speculates that the agoraphiles profit at the expense of agoraphobes. Those households that do refinance their mortgage enjoy a better rate precisely because the remainder do not. As a consequence, lenders who wanted to introduce a self-refinancing mortgage would face a conundrum. Naive householders would benefit from such a product, but if they knew that, they would no longer be naive (and would not need it).

Mr McFadden takes all this a step further. The “consumer may need to be coaxed and wheedled into responding to market choices with sufficient diligence,” he says. For his predecessors, such as Taussig, this is heresy. The consumers' choices are the data—the given things—of economics. It is only by observing a consumer's choices that economists can infer his preferences. Thus to argue that we know what's best for consumers, independent of what they have chosen for themselves, is a failure of logic as well as the height of presumption. If our theory fails to explain their behaviour, it is our problem, not theirs. Mr McFadden seems tempted by the opposite conclusion. If economic theory fails to reflect consumer behaviour, perhaps consumers can be remoulded, better to serve the theory.

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