Traditional economic theory assumes that consumers make rational decisions

that maximise their economic welfare, but behavioural economists disagree.

Using examples to illustrate your answer, explain how anchoring

and loss aversion can affect an individual’s choices when deciding
how to spend or save their income. [15 marks]

In economics, consumer spending on goods and services is referred to

as ‘consumption’ whilst ‘saving’ occurs when household income is not
spent. Traditional economic theory assumes spending and saving
decisions to be rooted in ‘rational utility maximising’ behaviour. This is
in contrast to behavioural economists who argue that psychological
cognitive biases such as anchoring and loss aversion may lead to
irrational decision making.

Anchoring, the cognitive bias of relying too much on a single piece of

information, may lead to individuals irrationally spending more and
hence saving less than traditional economists would expect. This is
because a single piece of information presented by the seller can imprint
itself in our mind and consequently acts as an influential reference point
for any future decisions. In terms of saving, people might have an
anchored rate of interest they believe worthy to save at. Therefore, if
interest rates fall past that rate, they will decide to spend their money
rather than save. Recommended Retail Prices (RRP) are an example a
commonly used anchor by many firms. This means that when prices fall
below the RRP it leads to consumers believing they are getting better
value which results in them spending and buying the good. For
example, an original offer price of £500,000 for a house for also acts as
an anchor, causing people to spend more (e.g. £450,000) than they
initially set out to pay for the house (£400,000). Consequently, anchoring
produces sub-optimal (non-utility maximisation) individual decision
making whereby more is spent and less is saved than traditional
economists would predict.
Loss aversion, the tendency to prefer avoiding losses to acquiring
equivalent gains, also leads to irrational decision when making spending
and saving decisions. Figure 1, illustrates the concept of loss aversion
where the differing perceptions of an equivalent gain of 1 (+1) compared
to a loss of 1 (-1) are shown in the stark contrast between the smaller
range for ‘x’(a gain) compared to that much greater ‘y’ (a loss).

Figure 1

This means that loss averse individuals avoid risk even if the chances of
winning are more than the chances of losing, because they place too
much value on what they have. In the context of saving, loss aversion
leads to people saving their money in safe but low-yielding bonds rather
than slightly riskier but potentially much higher yielding investments
which would consequently lead to more wealth and income (utility) in the
long run. Furthermore, loss averse people show an unwillingness to sell
their shares at a lower price than they paid for them, even if they could
invest the money in other shares which they believe are likelier to be a
better investment. The housing market provides a similar example where
loss averse home-owners are reluctant to sell their house for a price less
than they initially paid for it even though the prices of all other properties
have fallen.
The Government would like to improve the well-being of the
population by encouraging people to adopt a healthy diet. Using
your knowledge of both traditional economic theory and
behavioural economics, assess alternative policies that the
Government might adopt to try to achieve its objective [25 marks]

Markets are generally thought to work well. Changes in the relative

prices of goods serve to create signals and incentives to which firms and
consumers respond, allocating resources to where they produce the
most utility.

However, if there is a market failure present it is possible that

government intervention may be justified. The fact that 20% of 10-11
year olds are obese suggests that there is failure in the market for
unhealthy food. One type of market failure which may affect the market
for food is that consumers over- estimate the net benefit of unhealthy
foods. This is due to an informational failure or due to behavioural
heuristics that prevent them from making rational choices that maximise
their utility. With the former, consumers may be unaware of the
ingredients of their food or the potential health consequences of
consuming it. This results in demand for unhealthy foods being higher
than it would be if consumers had full information. As a result, market
signals produce undesirable outcomes, with too many resources being
allocated to the production of unhealthy foods and not enough to healthy
alternatives. With the second, consumers tend to put less weight on the
health consequences of eating sugary and fatty foods than they should,
simply because the health consequences are uncertain and will occur in
the future. The problem is that consumers over-discount the future,
putting too much store by immediate costs and benefits. Many studies by
behavioural economists have shown this to be true. A third form of
market failure is also present in food markets, namely negative
externalities in consumption of unhealthy foods which are demerit goods.
There are clear impacts on third parties who have no way of using the
market to charge for the damage incurred such the burden on the tax
payer that occurs from the cost of NHS to treat obesity related illnesses.
The marginal social benefit of consumption of unhealthy foods is thus
significantly less than the marginal private benefit, as shown in the
Figure 1. Too many resources are allocated to the production of
unhealthy foods, as the market mechanism output being greater then the
socially efficient output, shown by the consumer deadweight welfare loss
shaded in the diagram.
Figure 1

One traditional policy option the government could undertake to

encourage people to have a healthy diet is to tax unhealthy food and
drink such as the sugar tax which was introduced in April 2018. Imposing
a tax would effectively reduce the market failures arising from
overconsumption of unhealthy food and drink because a unit tax would
raise the cost of production for producers of unhealthy food and drink,
causing the supply curve to decrease (Figure 2: S1 to S2). At current
prices, there is excess demand for the good or service. Firms raise
prices (P1 to P2) to create new equilibrium and to safeguard profits.
Demand contracts causing consumption of unhealthy goods to fall from
(Q1 to Q2) because consumers will switch to other healthier alternatives
which are now comparably cheaper or less expensive. Evidence of the
sugar tax in Mexico supports the success of this policy, with sales of
sugary foods decreasing by 12% in the first year of the tax. The tax
internalities the externality, making the producer and consumer cover the
cost of its negative effects on third parties. Taxes are an especially
effective policy because the revenue raised (total shaded area in
diagram) to finance other government policies that aim to reduce
consumption of unhealthy foods, such as subsidies or behavioural
policies.
Figure 2

However, the tax is unlikely to be effective in reducing consumption to

the socially efficient output because it is difficult to put a monetary value
on the cost of a negative externality. It is also unlikely that the socially
efficient output is reached because demand for unhealthy foods is price
inelastic and therefore not very responsive. This is because, in the eyes
of many consumers, healthy substitutes to food (such as a banana for a
flapjack) are not a close substitute. Fatty processed foods and sugary
drinks have ingredients that are addictive to humans and therefore can
be considered habit-forming goods. It is likely that cross elasticity of
demand with these two products will be a very low positive score.
Therefore, consumption will fall less than proportionately when the price
increases. The sugar tax is regressive because it will take a higher
percentage of income from those on low-incomes. Also, if PED inelastic
this means that consumer pays the highest burden (shaded red in the
diagram), which from a normative perspective, many would argue is
unfair to the consumer, especially when they are being nudged to buy
unhealthy food and drink through psychological heuristics such as
herding and framing. Behavioural policies that make demand more
elastic would therefore be more effective at improving people’s diets
than a tax on unhealthy food.

Another traditional policy is to improve information about the health

content of healthy and unhealthy foods. For example, the government
could enforce restaurants, takeaways, fast food outlets and others to
provide calorie information. This policy helps individuals more effectively
weigh up the benefits and costs of consuming different foods, allowing
them to make choices that maximise utility. Closing the information gap
could thus in theory decrease the demand of unhealthy foods towards
the socially optimal level. If informational failures are the root cause of
the market failure, this policy will be a direct, therefore effective solution.
However, evidence suggests that this policy is unlikely to be effective
because consumers already have good information. The UK already
has compulsory food labelling of ingredients and numerous campaigns
to advertise a healthy diet such as the Change4Life initiative. The
Consumer Protection Act (2007) already protects consumers against
misleading advertising suggesting that information provision cannot
easily be improved. On simpler terms, it is common knowledge that a
flapjack is an unhealthier choice than a banana, yet there is still
overconsumption of flapjacks and other unhealthy food and drink.
Furthermore, closing the information gap fails to deal with the problem
that people are not computing the value of costs and benefits occurring
years into the future, such as eating a flapjack every day can increase
risk of Type 2 diabetes. Information provision will therefore likely result in
government failure because the cost of introducing the policy (which has
an opportunity costs as it can be spent on other market failure
initiatives), will outweigh the gains, so resources are not allocated more
efficiently.

This suggests that the market failure stems from behavioural reasons.
Consumers are showing signs of bounded rationality (people’s ability to
make rational decisions is severely limited because of the human mind’s
limited ability to evaluate information) and bounded self control (inability
to control aspects of our own behaviour). Individual decision making can
be influenced more effectively using choice architecture: changing the
way information and choices are presented to us, nudging us to make
socially optimal decisions that maximise utility. One example is that the
government could legislate that healthy food must be placed on
supermarket shares where they are more likely to be purchased (e.g. at
eye level, near checkout and under attractive lighting). Another example
is that they could force producers of unhealthy products to frame
information in an unfavourable way so that less consumers are attracted
to buy and consume these goods, making the demand for them less
price inelastic as consumers will be more open to substitutes. For
example, unhealthy yoghurt could be labelled “80% fat” rather than “20%
fat free”, making it less attractive to consumers, causing demand to fall.
There are very few disadvantages of behavioural policies. Behavioural
economics may encourage government to become too paternalistic.
However, these polices do not restrict a consumer’s freedom to choose
to consume an unhealthy product, weakening this argument.
Furthermore, it might be a case that the end justifies the means because
the paternalistic manipulative nature of these policies will result in a
positive effect on society by improving people’s diet. Secondly, financing
these polices come at an opportunity cost, although it is quite small
compared to full regulation of the market or subsidies to producers of
healthy food and drink. This creates a very strong case in favour that
behavioural policies are the most effective tool the government could
use to promote a healthy diet among consumers.

To conclude, because the root cause of market failure in the market for
food and drink is due to behavioural reasons, behavioural policies would
be the best way for the government to improve the well-being of the
population by encouraging people to adopt a healthy diet. People are
‘predictably irrational’ therefore government policies that exploit this and
nudge consumers to make utility maximising decisions through choice
architecture and framing, would be the most effective way of reducing
overconsumption of unhealthy food, leading people to have a heathier
diet.