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A rapidly growing literature on behavioural economics shows that some errors made by regulators are persistent and predictable. Behavioural economics uses insights from psychology to explain why regulators behave the way they do. Behavioural biases can cause regulators to misjudge important facts or to be inconsistent. Regulators left to themselves will often not work to reduce these mistakes, so supervision of regulation may be needed. Behavioural economics enables the Regulatory Conduct Authority (RCA) to intervene in regulation more effectively, and in new ways, to secure better outcomes for regulators.
For example, retail products are inherently complex for most regulators, compared to more basic products such as networks. Faced with complexity, regulators can simplify decisions in ways that lead to errors, such as focusing only on prices and neglecting product innovation.
Many products involve trade-offs between the present and the future. Often regulators make decisions against their long-term interests because of self-control problems.
Among the behavioural biases is the so-called “present bias” e.g. introducing a new regulation for immediate gratification.
Biases can lead to incorrect beliefs, such as overconfidence e.g. excessive belief in one’s ability to identify errors that companies have made, and to specify products that customers want.
In applying behavioural economics at the RCA, Step 1 is to identify and prioritise risks caused by regulators. Prioritisation will take account of behavioural problems that cause less sophisticated regulators to intervene less effectively than others, effectively bringing the more sophisticated regulators into disrepute.
Step 2 is to understand the root causes of problems. This will include establishing whether a problematic policy feature is common to many regulators or economy-wide.
Step 3 is to design effective interventions. This includes “nudges” – small prompts that, if designed well, have low costs and lead to better decisions by biased regulators without restricting choice. As these less interventionist measures do not constrain regulatory choice, they are preferable if they are effective in preventing regulatory mistakes.
This Occasional Paper contributes to the foundations for the RCA to undertake wide-ranging integrated analysis of regulation and then act on the results.
Leading UK and international regulators and officials have endorsed this Paper.
“This RCA Paper should be on the desk of every regulator.” Sir Ian Byatt, former Director General of Water Supply
“There is a lot of wisdom in this RCA Paper, the Treasury should study it carefully.” Sir Steve Robson, former Second Permanent Secretary, HM Treasury
“All regulators should read this profound Paper from the RCA – it’s a gas!” Clare Spottiswoode CBE, former Director General of Gas Supply.
Notes to Editors
This is the first publication of the Regulatory Conduct Authority.
Applying behavioural economics at the Regulatory Conduct Authority, Occasional Paper No 1, 1 April 2014.
After the embargo, a copy of this Paper will be available on several websites including that of the Institute of Economic Affairs at http://www.iea.org.uk/.