Archive for November, 2018

Health insurance, financial investments, telecom service plans — consumers frequently find it harder to make choice decisions in these exemplar domains. Such domains are more susceptible to exhibiting greater complexity: details, many and technical, to account for, multiple options difficult to differentiate and to choose from, and unclear consequences. In products, we may refer in particular to those involving digital technology and computer-based software that some consumers are likely to find more cumbersome to navigate and operate. When consumers are struggling to make any choice, they develop a stronger tendency to delay or avoid the decision at all. They need assistance or guidance in making their way towards a choice that more closely matches their needs or goals and preferences.

Handel and Schwartzstein (2018) are distinguishing between two mechanism types that obstruct or interfere with making rational decisions: frictions and mental gaps.

Frictions reflect costs in acquiring and processing information. They are likely to occur in earlier stages of a decision process when consumers are encountering difficulties in searching for and sorting through relevant information (e.g., what options are more suitable, what attributes and values to look at), and they have to invest time and effort in tracing the information and organising it. Furthermore, frictions may include the case when consumers fail to see in advance or anticipate the benefits from an available alternative  (e.g., consider the difficulty of older people to realise the benefits they may gain from smartphones).

Mental gaps are likely to make an impact at a more advanced stage: the consumer already has the relevant information set in front of him or her but misinterprets its meanings or does not understand correctly the implications and consequences of any given option (e.g., failing to map correctly the relation between insurance premium and coverage). Mental gaps pertain to “psychological distortions” that generally may occur during information-gathering,  attention and processing, but their significance is primarily in comprehension of the information obtained. In summary, it is “a gap between what people think and what they should rationally think given costs.”

In practice, it is difficult to identify which type of mechanism is acting as an obstacle on the way of consumers to a rational decision.  Research techniques are not necessarily successful in separating between a friction and a mental gap as sources of misinformed choices (e.g., choosing a dominated option instead of a dominating one apparent to the rational decision-maker). Notwithstanding, Handel and Schwartzstein are critical of research practices that focus on a single mechanism and ignore alternative explanations. In their view, disregard to the distinction between mechanisms can lead to spurious conclusions. They suggest using counterfactual approaches that test a certain mechanism, or a combination of explanations, and then argue against it with a ‘better’ prospective mechanism explanation. They also refer to survey-based and experimental research methods for distinguishing frictions and mental gaps. The aim of these methods is to track the sources of misinformed decisions.

Consumers often run into difficulty with financial investments and saving plans. In some countries policy makers are challenged with driving consumers-employees towards saving for retirement during the working years. Persuasion per se turns out to be ineffective and other approaches for directing or nudging consumers into saving are designed and implemented (e.g., encouraging people to “roll into saving” through a scheme known as ‘Save More Tomorrow’ by Thaler and Sunstein).

Confronting employees with a long list of saving plans or pension funds may deter them from duly attending to the alternatives in order to make a decision, and even risks their aborting the mission. When consumers-employees have a hard time to recognise differences between the plans or funds (e.g., terms of deposit, assets invested in, returns), they are likely to turn to heuristics that brutally cut through the list. Crucially, even if information on key parameters is available for each option, decision-makers may use only a small part of it. Similar difficulties in choosing between options may arise in financial investments, for instance when choosing between equity and index funds or bond funds. One may be assisted by suggesting a default plan (preferably, recommending a personally customised plan) or sorting and grouping the proposed plans and funds into classes (e.g., by risk level or time horizon). However, it should be acknowledged that consumer responses as described above may harbour frictions as well as mental gaps, and it could help to identify which mechanism has the greater weight in the decision process.

A key issue with health insurance concerns the mapping of relationship between an insurance premium and the level of deductibles or cost-sharing between the insurer and the insured. For example, consumers fall into a trap of accepting an insurance policy offered with a lower premium while not noticing a higher deductible they would have to pay in a future claim. An additional issue consumers have to attend to is the coverage provided for different medical procedures such as treatments and surgeries (given also the deductible level or rate). Consumers may stumble in their decision process while studying health insurance plans as well as while evaluating them.

  • Public HMOs (‘Kupot Holim’) in Israel offer expanded and premium health insurance plans as supplementary to what consumers are entitled to by the State Health Insurance Act. Yet in recent years insurance companies are prompting consumers to get an additional private health insurance plan from them — their argument is that following changes over the years in the HMOs’ plans and reforms by the government, those plans do not offer adequate coverage, or none at all, for more expensive treatments and surgeries. The coverage of private insurance plans is indeed more generous, but so are the much higher premiums , affordable to many only if paid for by the employer.

In addressing other aspects of healthcare, Handel and Schwartzstein raise the issue of consumer preference for a branded medication (non-prescription) over an equivalent and less costly generic or store-branded medication (e.g., buying Advil rather than a store-branded medication that contains the same active ingredient [ibuprofen] for pain relief as in Advil). Another vital issue concerns the tendency of patients to underweight the benefits of treatment by medications prescribed to them, and consequently do not take up medications satisfactorily as instructed to them by their physicians (e.g., patients with a heart condition, especially after a heart attack, who do not adhere as required to the medication regime administered to them).

Customers repeatedly get into feuds with their telecom service providers — mobile and landline phone communication , TV and Internet. Customers of mobile communications (‘cellular’), for example, often complain that the service plan they  had agreed to did not match their actual usage patterns or they did not understand properly the terms of the service contract they signed to. As a result, they have to pay excessive charges (e.g., for minutes beyond quota), or they are paying superfluous fixed costs.

With the advancement of technology the structure of mobile service plans has changed several times in the past twenty years. Mobile telecom companies today usually offer ‘global’ plans for smartphones that include first of all larger volumes of data (5GB, 10GB, 15GB etc.), and then practically an infinite or outright unlimited use of outgoing talking minutes and SMSs. While appealing at first, customers end up paying a fixed inclusive monthly payment that is too high relative to the traffic volume they actually make use of. On the one hand customers refrain from keeping track of their usage patterns because it is costly (a friction). On the other hand, customers fail in estimating their actual usage needs that will match the plan assigned to them (a mental gap). In fact, information on actual usage volumes is more available now (e.g., on invoices) but is not always easily accessible (e.g., more detailed usage patterns). It should be noted, however, that companies are not quick to replace a plan, not to mention voluntarily notifying customers of a mismatch that calls for upgrading or downgrading the plan.

A final example is dedicated here to housing compounds of assisted living for seniors. As people enter their retirement years (e.g., past 70) they may look for comfortable accommodation that will relieve them from the worries and troubles of maintaining their home apartment or house and will also provide them a safe and supportive environment. Housing compounds of assisted living offer residence units, usually of one or two rooms of moderate space, with an envelope of services: maintenance, medical supervision and aid, social and recreational activities (e.g., sports, games, course lectures on various topics). The terms for entering into assisted living housing can be nevertheless consequential and demanding. The costs involve mainly a leasing payment for the chosen residence and monthly maintenance fee payments.

Making the decision can be stressing and confusing. First, many elderly people cannot afford taking residence in such housing projects without selling their current home or possibly renting it (e.g., to cover a loan). In addition the value of the residence is depreciated over the years. Second, the maintenance fee is usually much higher than normal costs of living at home. Hence residents may need generous savings plus rental income in order to finance the luxury and comfort of assisted living. Except for the frictions that are likely to occur while looking for an appropriate and affordable housing compound, the prospect residents are highly likely to be affected by mental gaps in correctly understanding the consequences of moving into assisted living (and even their adult children may find the decision task challenging).

Methods of intervention from different approaches attempt to lead consumers to make decisions that better match their needs and provide them greater benefits or value. Handel and Schwartzstein distinguish between allocation policies that aim to direct or guide consumers to a recommended choice without looking into reasons or sources of the misinformed decisions (e.g., nudging techniques), and mechanism policies that attempt to resolve a misguided or misinformed choice decision by tackling a specific reason causing it, such as originating from a mechanism of friction or mental gap. From a perspective of welfare economics, the goal of an intervention policy of either type is to narrow down a wedge between the value consumers obtain from actual choices subject to frictions and mental gaps, and the value obtainable from a choice conditional on being free of frictions and mental gaps (i.e., assuming a rational decision). (Technical note: The wedge is depicted as a gap in value between a ‘demand curve’ and a ‘welfare curve’, respectively.)

Policies and methods of either approach have their advantages and disadvantages. An allocation policy has a potential for greater impact, that is, it can get farther in closing the welfare wedge.  Yet, it may be too blunt and excessive: while creating a welfare gain for some consumers, it may produce an undesirable welfare loss to consumers for whom the intervention is unfitting. Without knowing the source of error consumers make, it is argued that a nudging-type method (e.g., simplifying the structure of information display of options) could be insufficient or inappropriate to fix the real consumer mistake. A fault of allocation policies could particularly be, according to the authors, that they ignore heterogeneity in consumer preferences. Furthermore, and perhaps as a consequence, such policies overlook the presence of informed consumers who may contribute by leading to the introduction of far better products at lower prices.

Mechanism policies can in principle be more precise and effective while targeting specific causes of consumers’ mistakes, and hence correcting the costs of misinformed decisions without generating unnecessary losses to some of them. The impact could be more limited in magnitude, yet it would be measured. But achieving this outcome in practice, the authors acknowledge, can be difficult and complicated, requiring the application of some costly research methods or complex modelling approaches. They suggest that “[as] data depth and scope improve, empirically entangling mechanisms in a given context will become increasingly viable”.

The analysis by Handel and Schwarztsein of the effects of intervention policies — mechanism versus allocation — could come as too theoretical, building on familiar concepts of economic theory and models, furthermore being difficult and complicated to implement. Importantly, however, the authors open up a door for us to a wider view on sources of mistakes consumers make in decision-making and the differences between approaches aimed at improving the outcomes of their decisions. First, they clarify a distinction between mechanisms of frictions and mental gaps. Second, they contrast allocation policies (e.g., nudging) versus mechanism policies which they advocate. Third, to those less accustomed to the concepts of economic analysis, they demonstrate their ideas with practical real-world examples. Handel and Scwharzstein present a perspective well deserving to learn from.

Ron Ventura, Ph.D. (Marketing)


Frictions or Mental Gaps: What’s Behind the Information We (Don’t) Use and When Do We Care?; Benjamin Handel and Joshua Schwartzsetein, 2018; Journal of Economic Perspectives, Vol. 32 (1 – Winter), pp. 155-178. (doi: 10.1257 / jep.32.1.155)




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