May 18, 2008
Consumer Protection
How Much government Regulation to "Protect" Consumers?Becker
The consumer protection issue has been thrust into public attention by the housing debacle because many families have had lenders foreclose on their homes, while other home owners are in serious arrears on their mortgage payments. Ye neither consumer ignorance nor cognitive defects in consumer decision-making had much to do with the housing bubble. Many home owners with low education and earnings, and with limited financial acumen became homeowners toward the end of the bubble period. They tended to lose little from the bubble since they put almost no money down, and they were given low ("teaser") interest rates on their mortgages. They frequently walked away from their homes when prices dipped below the value of their mortgages, and lost little.
On the other hand, highly sophisticated lenders, including giant companies like Bear Stearns, Citibank and UBS, lost billions of dollars through paying too much for their mortgage-backed securities. Many top executives of these banks were out millions of dollars because they owned lots of shares of their companies, and they had generous options that went under water. Government regulators, not private incentives, created the important asymmetry between gains and losses to the executives of these companies. Financial leaders know that when many banks get into financial difficulties at the same time, the "too large to fail" principle of bank regulators would be applied, so that equity owners would be at least partially bailed out. Bear Stearns' equity investors lost a lot when JP Morgan purchased the company, but they would have lost more if the Fed had not guaranteed $29 billion of BS assets.
The consumer ignorance and cognitive defects stressed by Posner did not cause the housing bubble, for it was due to a belief that rising housing prices and the general good times would continue for much longer. Allan Greenspan, probably the greatest central banker of the past several decades, recognized that it is not easy to distinguish legitimate increases in prices from excessive price increases. The fact is that during price bubbles, regulators, including central bankers, usually get caught up in the same optimistic frenzy that drives participants. How would greater regulation have helped when commercial banks, one of the most heavily regulated of all industries, did so badly during this housing bubble?
I am not trying to deny that consumers often have very imperfect information about the products they buy, but they do not have to rely only on their own information. The advantage to companies of getting and maintaining their reputations as they compete for consumers is a powerful regulator of the quality of products that consumers receive. Shoppers, for example, rely on Whole Foods, Safeway, and other supermarkets to do much of the information processing for them, and consumers hold the supermarkets responsible for bad-tasting foods, and other products that do not live up to claims of their suppliers. It is not the diligence of regulators but the reputations of companies that are mainly responsible for all the high quality merchandise consumers purchase without having to know all the details.
I agree with Posner that companies do not want to "foul their nests", but still companies have had no hesitation in saying that they do not use trans fats-a purely voluntary provision of information to consumers not required by regulations- or that their cereals use oats that may be good for the heart, or that their products are lower than before in salt and fat, or that their airlines have better on-time records or more comfortable seats than competitors, or that their cars have better repair records or better hold their value as they age than cars of competitors, or that their drugs can prevent erectal dysfunction, lower cholesterol levels, treat pain better because of more powerful ingredients than in the past, or have other positive effects on the health and pleasure of consumers.
Posner seems to believe that consumers have less information than in the past because their time is more valuable and they are busier. Their time is more valuable in large measure because they have greater levels of human capital that increases their skills, and enables them to use and process information more effectively. The Internet has also made an enormous difference in enabling consumers to acquire information more easily, whether through offering comparisons of hotel rates and prices of cars being offered for sale, or through the provision of information about effectiveness and side effects of different drugs and medical procedures. The same factors that make time more valuable to consumers make it easier for them to acquire and process information about the products they buy.
Various groups have pushed in recent years for greater regulation of all types of consumer choices, including smoking, eating of fast foods, the ingredients allowed in foods, such as trans fats, the drinking of alcoholic beverages, and many other products and services. This pressure toward greater regulation of consumer choices is not the result of consumers finding it more difficult to get information about products and the consequences of consuming them. Nor have the cognitive defects referred to by Posner become more prevalent or harmful. Instead, the movement toward increased regulation of consumer choices reflects in large measure greater reluctance among some groups to accept these choices. It is unacceptable to many persons both inside and outside the medical profession that some individuals want to smoke or eat a lot and become overweight, even if they knew and possibly exaggerate the negative health consequences of smoking and overeating. The increase in weight of teenagers, for example, is not explained by cognitive biases, but by sharp declines in the cost of fast foods, and the development of Internet and other sedentary games.Increasing intervention in consumer choices also reflects the erosion of individual responsibility (see my discussion on March 16), so that consumers and their advocates blame others when consumer choices turn out to be harmful and costly.
I do not deny that regulations may be required when the consequences of mistakes are very serious, and when the forces unleashed by competition provide inadequate protection. One example is the permissibility of lawsuits against surgeons who make obvious mistakes during their surgeries, such as leaving sponges in a patient's body. Another possible example is the regulation of airline safety, although airlines suffer a lot when they have accidents, regardless of regulatory measures, and government safety regulations have often been inadequate and misleading.
Important exceptions notwithstanding, the overall trend toward greater regulation of consumer choices is disturbing. Consumers make worse decisions when they are not responsible for their decisions, or when they can sue or otherwise get compensated when they make bad decisions. Consumers make mistakes, but they learn from them when they have to bear the consequences of their decisions. They are generally far more competent to make decisions in their own interests than are regulators or lawmakers as long as consumers are the ones who benefit from good choices and are hurt by bad choices. This is why I continue to be a minimalist on government regulation, and greatly prefer the controls over behavior that stem from consumer responsibility and the discipline of competition.
Consumer Protection--Posner
The subprime mortgage debacle, efforts by New York City to ban trans fats in restaurants, the discovery of lead in toys manufactured in China, and concerns about safety inspections of airplanes and laxity in regulation of new drugs have brought to the fore the issue of the optimal scope and methods of regulation designed to protect consumers.
There are two reasons to think that consumers might need more protection than is provided by competition among sellers, even as backed up by court-enforced law. Few opponents of regulation doubt the appropriateness of such judicially enforced rules as the implied warranty of fitness and safety that accompanies the sale of products.
The first reason for thinking that it might make economic sense to add a layer of regulation to competition plus court-enforced law is the high costs to consumers of obtaining information about products and services (but I will confine my attention to products). The busier people are and hence the higher their costs of time, and the more complex that products are, the higher consumer information costs will be. Product information could be thought a product in itself that a competitive market would generate in optimal quantities, but that is far from certain. The problem is what might be called "fouling one's nest." If a cigarette producer advertises its cigarettes as "safer," it is implying that cigarettes are unsafe, and this could reduce consumption. Now in fact everyone knows about the dangers of smoking, so that is not a serious problem; but it is a problem when the hazards of a product are not widely known. A restaurant that advertises that its food contains less trans fat or less salt than other restaurants is telling consumers that there are bad things in restaurant food. Moreover, and probably more important, it is very difficult for an advertiser to explain why trans fat or salt or butter is bad for one. I believe that the obesity epidemic must be due in in part to the ignorance of many consumers, especially if they are poorly educated, of the causes and consequences of obesity.
There are three possible responses to the problem created by consumer information costs. The first is to require producers to provide more information; the second is to ban products upon on the basis of a judgment that if consumers knew the score they would not buy the product in question; and the third is to leave the burden of information on the consumer, thereby increasing the incentive of a consumer to inform himself about the products he buys. Often the preferred ranking will be 2, 1, and 3. Banning the product eliminates information costs, though to justify so drastic a measure requires a high degree of confidence that informed consumers would not buy the product if they knew the facts about it. If as I believe trans fats have close and much more healthful substitutes that cost little more than trans fats, the attempt to ban trans fats in New York City restaurants made sense.
Forcing sellers to provide more information to consumers can paradoxically raise consumer information costs by requiring consumers to sort through more warnings and interpret and evaluate them. There is also a lulling effect: required warnings create the impression that the government is protecting consumers by regulating sellers, which it may not in fact be doing; or may create resentment because consumers feel overloaded with unnecessary warnings: a "crying wolf" problem. A related problem is that consumers have very different stocks of information, making it difficult or even impossible to draft a warning that will provide a significant net increment in consumer knowledge.
Finally, encouraging consumers to become better informed about products on their own, in lieu of relying on government regulation, might be excessively costly. It would force consumers with high time costs to reallocate high-value time to the study of consumer products, at a cost and a cost of this reallocation that might exceed the cost of regulation. Take the case of health inspections of restaurants. My guess is that those inspections add little to the cost of restaurant food (I am assuming the inspections are financed by a restaurant tax). In their absence a consumer could not just drop in on a new restaurant with confidence that he would not get sick because of unsanitary conditions. (So such regulation may encourage entry into the restaurant industry.) No doubt services would spring up to rate the healthfulness of different restaurants, just as services like Zagat rate the quality of the food and service offered in different restaurants. But the inspectors employed by a private service would not have the powers of public inspectors--to inspect without notice and shut down a restaurant found to have unhealthful conditions. Perhaps some restaurants would consent to grant such powers to a private service, but then the consumer in evaluating the private inspection services might be faced with a formidable search cost to determine the best service.
Apart from costs of obaining information, there is the distinct problem of evaluating or processing information. This is the domain of the cognitive quirks that have been illuminated by the recent literature (increasingly influential in economics) in cognitive psychology. An example is the seeming inability of many consumers to appreciate the practical identity between an item priced at $9.99 and the identical item priced at $10.00. Merchants' unquestionably sound conviction that consumers exaggerate the difference between these two prices is the only thing keeping the penny in circulation, as it costs more than a penny for the U.S. Mint to produce a penny.
I do not think these quirks provide a compelling reason for additional regulation of consumer products and services. Such regulation would amount to telling consumers that they can't think straight, and would reduce consumer utility, at least in the short run, by denying them $9.99 "bargains." I would however favor incorporating into the curricula of high schools, and perhaps even elementary schools, courses in cognitive psychology that would make students alert to the pitfalls that await them as a result of cognitive defects that, though hard-wired in the brain, are avoidable if one is alert to their existence.
The existence of cognitive deficiencies may have been a factor in the subprime mortgage debacle, though on the consumer rather than the producer side. Many consumers may have been incapable of properly evaluating the risks of heavy borrowing; cognitive psychologists have found that average and even very intelligent people have difficulty handling probabilities. On the producer side of markets, however, there are forces for minimizing the effect of cognitive deficiencies. People who don't handle probabilities well are not going to thrive in the insurance business or other financial businesses. They will be selected out by competition; the analogy is to natural selection in biological evolution. I suspect that the housing bubble and ensuing credit crunch reflect, on the business side of the market, not so much irrational optimism as risk taking that was rational given asymmetries of loss and gain. Generous severance benefits truncate downside risk for the top management of large companies, and speculation in the face of a known bubble can be rational because until the bubble bursts values are rising very rapidly; the trick is to jump off the hurtling train just before it crashes.