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Product literacy and the economics of consumer protection policy.

I suffer from overoptimism bias. I know this, yet I accepted the invitation to write a commentary on product literacy and consumer protection for this special issue. After devoting over twenty-five years to consumer protection research and law enforcement at the Federal Trade Commission (FTC), the topic was in my wheelhouse. Surely, I could meet a deadline that seemed reasonably far away. But I also suffer from hyperbolic discounting, so I procrastinated. When I finally sat down in earnest to write this essay, panic set in, because I realized that the concept of product literacy is not well defined. Now what? Relying on my overoptimism, I decided to create my own definition.

This exercise forced me to confront vexing questions about competing theories of consumer behavior and their implications for consumer policy. Consumer policy development depends fundamentally on the policy maker's view of consumer behavior. Policies will differ depending upon whether consumer decisions are viewed as rational, irrational, or somewhere in between. Yet, theories regarding rational consumer choice are in a state of flux, largely due to the growth and popularization of behavioral economics. Popular books such as Nudge have placed behavioral economics front and center in consumer policy circles (Thaler and Sunstein 2008). It is now fashionable inside the Washington DC Beltway to point to behavioral research suggesting that consumers do not maximize wealth, are overly optimistic, or procrastinate due to hyperbolic discounting, as proof that policies based on rational consumer models are insufficient to protect consumers (Kobayashi et al. 2012). This conclusion is then frequently used to argue that new policies should be implemented to protect people from their irrational selves. For example, some argue that mandating information disclosures from sellers is not enough--because consumers do not pay enough attention to them--and that disclosure regimes should be supplemented with or replaced by more prescriptive remedies, such as product bans or product preapproval mechanisms (Ben-Shahar and Schneider 2011; Posner and Weyl 2012).

Although the future of consumer policy will be shaped by prevailing views of consumer rationality, there is surprisingly little serious debate among scholars from different disciplines or subdisciplines about the evidence for and against different models of consumer decision making. There are notable exceptions, but even when meaningful debate occurs it is often clouded by confusion over the precise meaning of key terms. What does it really mean for a consumer to be rational, or irrational, or reasonable? Discussion in behavioral circles tends to focus on whether people behave rationally, in the sense that people maximize an unconstrained or partially constrained utility problem. Evidence that people do not behave according to simple utility maximization models is often seen as evidence that people are not rational. What I find perplexing is why the standard for rationality in behavioral discussions tends to be based on utility maximization or wealth maximization constrained only by limited financial resources. I find this perplexing because the economics of consumer behavior, as taught in graduate school over thirty years ago, was based on a much more realistic model of consumer choice. When I explain this at conferences I encounter surprise by practitioners and scholars who are fluent in behavioral economics. Consumer economists have long understood that consumers face real time constraints, wealth constraints, and household production constraints, including decision-making and information-processing constraints.

In this essay, I define product literacy and discuss where the concept fits within the law and economics of consumer protection. In so doing, I attempt to clarify what it means to be a rational consumer vs. a reasonable consumer vs. an irrational consumer. These different views of consumer behavior matter, because they can lead to different policies with different implications for consumer choice and consumer welfare. Most importantly for consumer protection, I note that the FTC's consumer protection policy is based upon a reasonable consumer standard. I argue that the reasonable consumer standard is quite consistent with consumer economics models of consumer behavior, in which consumers maximize utility (not necessarily wealth) subject to wealth constraints, time constraints, and household production constraints. By highlighting confusion over the definitions of key terms, I hope to nudge scholars toward more productive debate about consumer behavior and best practices for consumer protection in the twenty-first century.

A CONSUMER ECONOMIST'S DEFINITION OF PRODUCT LITERACY

I approach the question of what it means to achieve product literacy from the perspective of someone trained as a consumer economist at Cornell University during the 1980s. Cornell's department of Consumer Economics and Housing (now the department of Policy Analysis and Management) was led by a new breed of economists, such as W. Keith Bryant and E. Scott Maynes. Following the work of economists such as Gary Becker and Reuben Groneau, students learned to model household behavior by applying the "new home economics" to an array of consumer choice questions. The heart of the basic training on the consumer side of the market can be found in Bryant and Zick (2006). A recent example of this type of modeling can be found in the work of John Cawley (2004), who examines how households combine inputs to achieve desired health outcomes. To understand the interaction between firm behavior and consumer behavior we delved into the newly developing literature on the economics of information (Salop and Stiglitz 1977; Stigler 1961; Wilde and Schwartz 1979). This training provided a framework for understanding both sides of the market--supply and demand. The primary focus, however, was on the behavior of real people facing real constraints. Looking back, we were working in the realm of behavioral economics before the term became fashionable. We used economics as a tool to help reveal behavioral patterns about important individual and family decisions using data from real consumers.

I would say that a person attains product literacy when he or she possesses the tools necessary to determine if a particular product of service will meet his of her goals given his or her limited resources--including limited wealth, limited time, and limited household production capabilities. Product literacy requires that three conditions be met. First, consumers need to estimate the net benefit of spending scarce resources to obtain product information. Consumers need a sense of the likely costs and benefits of obtaining additional information and knowledge. Second, consumers need to comprehend this information. Third, consumers need a way to evaluate this information and relevant choices. Product literacy does not require that consumers have perfect information, only that they obtain enough information to make a reasonably good decision. What is reasonable in one case, where stakes are high, may not be reasonable in another case, where stakes are low.

This definition of product literacy follows directly from consumer economics models of household behavior, where people have unique preferences for higher level goods (such as health) but face wealth, time, and household production technology constraints. People allocate time and money to buy goods and services to attain their higher level goals. In such models people only learn enough about a product of service to make an informed choice, which ex ante, would solve a constrained utility maximization problem. Let me be perfectly clear about what I mean by this. I do not mean that consumers write down utility maximization problems and solve for a global maximum. Rather, I mean that consumers have the skills and knowledge to make reasonable choices that will provide the greatest satisfaction, in light of their many constraints.

I also want to make clear that a reasonably informed consumer is not necessarily a perfectly informed consumer. That is, it rarely, if ever, makes sense to gather all possible knowledge about a good or service because the process of obtaining information and translating it into knowledge is costly. A reasonable person will only invest in knowledge up to the point where the expected marginal benefit of gaining additional knowledge is equal to the expected marginal cost. As John Vickers stated,
 Indeed, the best solutions often involve better consumer
 information rather than less consumer and producer choice. But
 improving consumer information is often easier said than done.
 especially information that is of immediate and direct practical
 use--for as consumers we are all boundedly rational, and rationally
 so. (2003, p.17)


Constraints matter. If consumers appear to behave irrationally, then one should consider the consumer's constraints and alternatives before concluding that a decision is not rational. Income constraints matter. For example, the optimal choice for someone facing a credit constraint is different from the optimal choice for someone who is not credit constrained (Elliehausen 2010).

Time and information-processing constraints also matter. Consumers who appear to respond inappropriately to information disclosures may actually be acting rationally in response to information that is incomprehensible, making the cost of comprehension prohibitive. One example is work on mutual fund disclosures. Researchers have suggested that disclosures failed because they did not lead to optimal decisions by participants. However, the researchers never tested how participants comprehended the disclosures. Participants may never have understood from the disclosure that they should focus on fund fees, because this is not highlighted for them (Beshears et al. 2011). If disclosures appear to fail, one must ask if the disclosure designers failed or if the consumer failed. Consumer researchers understand that even experts are not good at predicting consumer opinions and reactions to communication efforts (Pappalardo 1997a, 1997b citing Armstrong 1991; Hoch 1988). This is why marketers use consumer research to estimate reactions to advertising campaigns and why such research is often needed to design disclosures that people will understand as intended.

A distinction must be made between bad decisions and bad outcomes. Risk and uncertainty are everywhere. As a result, good decision-making processes can lead to bad outcomes, and vice versa. We cannot simply observe a bad outcome and infer that the outcome was the product of a bad decision. One concrete example is the post-2007 decline in the housing market. There is no doubt that some people who invested in housing did not understand the true costs of home ownership, in part because many consumers did not know how to parse mortgage loan documents (Lacko and Pappalardo 2007, 2010). Yet, some analysts contend that the main problem on the consumer side of the market was a failure to predict if and when a housing price turning point would occur, and that even if people fully understood mortgage costs, most still would have purchased the same property, using the same mortgage, because they expected housing prices to rise enough to turn the purchase into a positive investment (Foote, Gerardi, and Willen 2012). The bad outcome of purchasing a home that declined in value was not necessarily the product of a bad decision process, but rather, may have been the product of assuming an investment risk.

PRODUCT LITERACY AND THE REASONABLE CONSUMER STANDARD

Different institutions have different objectives and mandates to protect consumers, and these differences dictate the design and implementation of their consumer protection policies. Here, I discuss the mission of the FTC. The FTC has a broad mandate to promote competition and protect consumers across a range of industries. The FTC's consumer protection policy is well developed through research, policy, and case law. Many of the principles for consumer protection developed by the FTC can be applied more broadly to other areas. The FTC has a long history of providing comments and assistance to state, national, and international consumer protection regulators.

The general mandate to protect consumers comes from Section 5 of the Federal Trade Commission Act. According the FTC Act, "unfair or deceptive acts or practices in or affecting commerce are hereby declared unlawful." The prohibition on deceptive acts or practices gives the FTC authority to prohibit fraudulent and misleading marketing, including misleading implied claims. What matters for deception is not simply what words are uttered or written on paper, but consumer interpretation of the net impression of marketing.

The deception standard has evolved over time. Thirty years ago, practices were prohibited if they had the capacity to mislead the "ignorant, unthinking, and credulous" (Gold Bullion Intl Ltd. 1978). Since the release of the Commission's Deception Policy Statement in 1983, the standard has been to prohibit a "representation, omission, or practice that is likely to mislead the consumer acting reasonably in the circumstances, to the consumer's detriment" (FTC 1983).

The standard for unfairness has also evolved over time. One key element of the unfairness policy is that the act or practice causes substantial injury to consumers. In 1980, the Commission released its Unfairness Policy Statement, which describes actionable injury to be substantial, not reasonably avoidable by consumers, and not outweighed by countervailing benefits to consumers of competition (FTC 1980). This reflects the FTC's joint mission to promote competition and to protect consumers. The joint mandate is a critical element of the FTC's mandate. The promotion of competition is paramount to developing a system that provides consumers with the goods and service they would like, at the lowest prices (Pautler 2008; Salinger 2010).

The FTC's focus on reasonable consumers is evident in the Deception Policy statement, which relates to people "acting reasonably under the circumstances" (Miller 1983). It is also evident in the Unfairness Statement, with its focus on injury "not reasonably avoidable by consumers." When it comes to law enforcement and consumer policy development, the Commission evaluates practices according to the effect on the target audience, who are not expected to be sophisticated experts. As former Chairman James Miller writes: "The reasonable consumer standard is not complicated: it simply requires that we interpret ads as ordinary consumers do." He also writes: "Reasonableness does not require any particular level of sophistication or education on the part of consumers" (Miller 1984). Case law reflects a long-held view that what is reasonable depends upon the context and consumer circumstances, including the psychological state of relevant consumers (Travel King 1975).

The reasonable consumer standard clearly does not require that consumers be unconstrained utility maximizers. I would argue that the reasonable consumer standard is consistent with consumer economics models of consumer behavior, which incorporate the notion that consumers face real time constraints, wealth constraints, and household production constraints, including decision-making and information-processing constraints. Although there are some who would argue that consumer policy ought to be changed in light of new findings from the behavioral economics literature, I believe that the reasonable consumer standard still strikes the best balance for consumer policy (Elliehausen 2010; Mulholland 2007; Salinger 2010).

WHERE DOES PRODUCT LITERACY FIT IN THE CONSUMER PROTECTION POLICY CONTINUUM?

Behavioral economics has contributed to consumer policy by broadening the range of consumer policy options. Several years ago, I wrote about the pros and cons of three options: inform consumers, educate consumers, of regulate product characteristics (Pappalardo 1997a, 1997b). This ordering was not accidental; I tried to arrange policies on a continuum ranging from least prescriptive (or least judgmental) to most prescriptive (or most judgmental). I also discussed the importance of considering the costs and benefits of these different approaches.
 Consumer policy makers must consider not only which
 strategy--direct regulation, information provision, or consumer
 education--is likely to solve a problem most efficiently, but also
 who in the consumer protection environment is relatively efficient
 at achieving the desired goal. (p. 30)


Today, I would add to this continuum two policy options highlighted in the behavioral economics literature: default nudges and individualized decision tools. Default remedies are more prescriptive than education remedies, but less prescriptive than a product ban. Default setting requires a value judgment about what choice most people would make if they had full information. If policy makers are correct in their assessment, then changing default settings can improve consumer welfare. If policy makers misjudge this choice, then a change in default setting can make people worse off. One concrete example in the mortgage market is the suggestion that the default mortgage for consumers ought to be the thirty-year fixed-rate mortgage, and consumers would need to opt out of this option if they choose an alternative. This nudge presumes that most people, if fully informed, would choose this option. There is considerable debate, however, over whether the thirty-year fixed-rate mortgage popular in the United States really is the mortgage that best matches most people's needs. One problem is that most people do not hold a mortgage for thirty years, and it is not clear whether it makes sense to pay a premium for fixing an interest rate over such a long time horizon (Bible and Joiner 2009; Campbell and Cocco 2003).

Individualized decision tools, made possible by new technology such as smart phones, are an important addition to the consumer protection policy continuum. Like any education policy, they involve some value judgment by the tool designer to determine which options are best for an individual. Individualized tools hold great promise, however, because consumers may be allowed to determine the relative importance of many attributes involved in complex decisions. For example, recommender tools may help people to identify the "consideration set" of options that is best for them. Social psychologists and marketing researchers such as John Lynch have long understood that consumer choices depend critically on the options that enter into a person's consideration set. Lynch (2009) has been working to develop a choice tool for housing and mortgage purchase decisions. Another example is work by the Obama administration to promote Smart Disclosure, which encourages making machine readable data available to third parties who can develop choice tools using data about product options (Sunstein 2011).

When considering where product literacy fits on the consumer protection policy continuum, I find that it straddles information and education remedies. Product literacy requires accurate information and a means of evaluating that information. Obviously, product literacy is thwarted when consumers do not have access to the quality and type of information necessary to evaluate product choices. Thus, truthful information is necessary for product literacy. In addition, truthful information alone may not be sufficient to achieve product literacy, because information is useless if one does not understand how to use it and transform it into practical knowledge.

The idea of moving beyond one-size-fits-all consumer information and education policies through the development of tools that can allow consumers to weigh product characteristics that are most important to them is exciting. The ultimate success of such decision tools will depend crucially on the accuracy of the data used to populate the tools, and the ability of developers to capture the essence of decision-making criteria that accurately match consumer preferences and constraints. This brings us back to a necessary condition for product literacy--a well-functioning information environment.

INFORMATION, COMPREHENSION, AND PRODUCT LITERACY

I would like to summarize a few key points about the economics of information, and information regulation. First, despite the existence of incentives for firms to provide truthful information, firms also have incentives to stretch the truth or to outright lie. When information markets fail, there is a potential role for government intervention (Darby and Karni 1973). Second, remedies to fix the information market often fail, because regulators do not conduct sufficient consumer research to ensure that such remedies are understood and used by consumers as intended (Lacko and Pappalardo 2004, 2007, 2010). Third, past failures of information remedies do not imply that information remedies will necessarily fail. Information remedies based on serious, controlled, quantitative consumer research can succeed (Lacko and Pappalardo 2004, 2007, 2010). Finally, discourse among consumer policy analysts can be elevated by clarifying the concept of consumer information. There is often a difference between consumer information and consumer comprehension. This difference matters.

Basic economics teaches that consumer demand for a good depends on the good's price, the prices of other goods, and consumers' income, information, expectations, and tastes/preferences. This simple model is remarkably powerful. But in practice, the model's predictive power depends on how well we can measure the relevant variables, including information. In theory, information affects consumer choice in predictable ways--positive news about a product tends to increase demand, ceteris paribus, and negative news about a product tends to decrease demand, ceteris paribus. In practice, however, marketing research has long shown that consumers do not necessarily comprehend information as expected by information providers.

For example, FTC research on mandated mortgage disclosures shows that some mandated disclosures are so confusing that "bad" attributes are mistakenly comprehended to be "good" attributes (Lacko and Pappalardo 2007). A recent mortgage purchaser thought that a "discount fee" was a discount for being a good customer rather than a fee paid for a mortgage with a given interest rate and upfront fees. Such comprehension reversals would theoretically result in demand reversals too. The consumer who mistakenly believed that a negative attribute (a fee) was a positive attribute (a discount) may have selected the wrong mortgage product as a result of this confusing disclosure. Economic theory is of limited practical use for information regulators unless the theoretical construct of information in standard demand analysis is translated into meaningful measures of consumer information comprehension.

To meet the challenge of obtaining meaningful measures of information quality and quantity, FTC economists often supplement economic analysis with marketing research techniques, such as content analysis and copy-tests. Communication copy-tests are routinely used to gauge consumer interpretation of advertising messages before firms launch marketing campaigns. The same techniques can also be used to test consumer interpretation of information intended to help consumers. Our work at the FTC demonstrates the benefit of basing consumer information policy on controlled, quantitative, consumer comprehension research. Similar work on nutrition labels by FDA staff and others also illustrates the benefit of such research (Andrews, Burton, and Kees 2011; Andrews, Burton, and Netemeyer 2000; Levy, Fein, and Schucker 1996), as does work on disclosure design by financial regulators (Garrison et al. 2012). One key element to the research is the use of objective measures to estimate consumer comprehension across different test and treatment conditions.

The federal government is beginning to recognize more broadly the value of consumer research to ensure that information remedies work as intended. Research on the FTC's energy-use label was highlighted by Office of Management and Budget Administrator Cass R. Sunstein in a memorandum on "Disclosure and Simplification as Regulatory Tools" to the heads of executive departments and agencies (Sunstein 2010). He directed executive branch regulators to test consumer information regulations, whenever feasible, to ensure that they will meet regulatory objectives. Several principles for the development of disclosures and other consumer policy tools are set forth in the document. One principle is that "Summary disclosure through ratings or scales should be meaningful." Sunstein writes:
 Agencies should select numbers and scales that are meaningful to
 users. For example, the Energy Guide label provides an estimate of
 annual operating costs, along with a cost range for similar models.
 Annual savings or benefits, measured in terms of dollars, provide a
 metric that is both meaningful and easy to understand. When
 monetary values are at stake, agencies should give careful
 consideration to disclosure of savings of benefits in terms of
 dollars. (p. 5)


Well-functioning information environments are necessary to attain the goal of product literacy. Information policy is unlikely to succeed, however, unless policy makers focus on consumer understanding rather than mete provision of words on paper.

QUESTIONS FOR THE NEXT GENERATION OF CONSUMER POLICY SCHOLARS

This is an exhilarating time to work on consumer protection policy. Recent problems in the housing market and the growing popularity of behavioral economics have thrust consumer protection into the limelight. Consumer policy conferences are alive with enthusiastic energy from a new generation of consumer policy advocates, analysts, and policy makers. The direction of consumer policy and its effects on consumer choice and consumer welfare will depend critically upon the working model of consumer behavior adopted by the next generation. Those who believe that consumers are not rational or not reasonable will be inclined to promote policies that restrict consumer choices in an effort to protect people from their own irrational or unreasonable behavior. Those who believe that consumers are generally rational or at least reasonable will likely advocate for policies that allow more individual choice. Information policies, which preserve individual choice, are unlikely to be effective unless the focus moves from providing information to providing useful information that reasonable consumers can comprehend. This will likely require more serious application of controlled, quantitative, consumer research designed to measure objectively what consumers actually understand. Research limited to asking consumers which disclosures they like or prefer is not always predictive of what is most useful in practice.

This is a time for serious reflection and debate among scholars in many fields who analyze consumer behavior, including the fields of consumer economics, marketing, psychology, information economics, experimental economics, law and economics, and behavioral economics. The central question is whether recent research in behavioral economics is sufficient to overturn the presumption that consumers act reasonably, and whether policy based on a reasonable consumer standard needs to be changed. The terms of the debate will depend upon the ability of scholars to develop a common language to clarify what it means for people to be rational, reasonable, or irrational. Other terms in the literature also need further clarification, including the terms boundedly rational, ecologically rational, and socially rational (Chase, Hertwig, and Gigerenzer 1998).

At this time I believe that the reasonable consumer standard, which is the centerpiece of consumer protection law at the FTC, is still reasonable. The Commission recognized long ago that consumers cannot be expected to be experts on all subjects and that consumer comprehension is what matters when determining whether an advertisement is deceptive. A reasonable consumer is not expected to be a perfectly informed consumer. The very concept of product literacy depends upon an assumption that people are reasonable. If a consensus emerges, after serious debate, that consumers are not reasonable, then there would be little benefit to the promotion of product literacy. For the very notion of product literacy is founded on the principle that consumers will make reasonably good choices when they have good information and good decision tools.

DOI: 10.1111/j/1745-6606.2012.01233.x

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* Invited article.

Janis K. Pappalardo (jpappalardo@ftc.gov) is with the Federal Trade Commission. The views expressed are those of the author and are not necessarily shared by the Federal Trade Commission of any individual commissioner. I thank my colleagues at the FTC for many spirited discussions about consumer protection law and economics, which have developed and challenged my views of consumer policy. I particularly thank James Lacko, David Schmidt, and Douglas Smith for providing comments on earlier drafts. I also thank Michael Shores, Julie Miller and Jack Mountjoy for excellent research assistance. All errors are my own.
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Title Annotation:REVIEWS AND COMMENTARY
Author:Pappalardo, Janis K.
Publication:Journal of Consumer Affairs
Date:Jun 22, 2012
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