The Sun (5th October 2019)

Six million Brits paying £200 too much for their insurance after being hit by ‘loyalty’ price hike

Syllabus Links

Rational Decision Making (Edexcel 1.2.10, AQA 4.1.2.1, OCR 1.1.1)

Check out the YouTube “Economics in Action” video here.

Potential questions

Explain, using a suitable diagram, how the theory of Diminishing Marginal Utility works

The government should not be concerned about the inability of private individuals to seek out the best prices. Discuss

Some ideas to consider:

Economics assumes that consumers, me and you, engage in rational behaviour. Our aim is to maximise the utility (satisfaction) we achieve from our consumption decisions, and as such, we will always ensure we do not pay too much for something. This article in the Sun, suggests that we do not behave rationally. Why is this an issue in Economics?

The law of demand is underpinned by a theory known as Diminishing Marginal Utility. Giving a simple example of this, if we buy a pizza and start eating it, we will enjoy the earlier slices of pizza more than the later ones. Once we start to fill up, the satisfaction, or extra (marginal) utility we gain will fall. Eventually that utility will become zero or negative. This can be shown on a diagram.

The MU curve represents the Marginal Utility (the addition to the total satisfaction of consuming one extra product). The curve slopes downwards as the more we consume (from Q1 to Q2), the less we start to enjoy it U1 to U2).

There is a useful moral to this story! When full, do not force yourself to eat those last two slices of pizza, save it for breakfast. We all know that cold pizza from the night before is one of the best breakfasts available!

How does this fit into your textbook economic theory? If we do not show rational behaviour and do not try to maximise our utility, then textbook economic theory is not accurate. This is why “Behavioural Economics” has become a more important part of the syllabus over recent years. We need to take into consideration the irrational behaviour of people and try to bring this element into our economic planning.

Why do we behave irrationally? There are several reasons that you need to be aware of. The first reason is due to “inertia”, and this is potentially the reason in our article. Once we set up a direct debit, we are more than content to let that direct debit continue. It is easy! We rarely check the details, the money goes out of the bank account, the cover continues. End of story! But that inertia, that idleness to check what you are paying, is costing you a lot of money! If anybody has the Norton antivirus, check out how much your last direct debit cost you, then check the current prices. I saved about £50 earlier this year by questioning it!

A second reason, related to the idea of inertia, is “habitual behaviour”. The idea that “this is what I have always done, and this is what I will continue to do!” I always do my shopping in ASDA despite cheaper alternatives being available, and I will continue to do my shopping in ASDA. What may seem like a rational choice based on routine, becomes irrational when we consider that other alternatives, potentially cheaper, are overlooked.

Political parties love this idea. “I have always voted (enter name of party), and I will continue to do so” regardless of whatever policies the party is offering you. Could Brexit spell the end of the two-party system as people now vote on big issues tactically?

A third reason why rational behaviour may not exist is our inability to compute all the information we have available. There is often too much information thrown at us, and unless we have significant amounts of time to read through it all, the easy option is to stick with what you already have. Think about mobile phone contracts, straight forward enough. But what about unit heating costs from energy firms? Mortgages? Bank loans? Now add the idea that we are more concerned with the trials of Thomas Shelby in Peaky Blinders, wading through pages of incoherent numbers becomes a chore too far!

We have something of a catch 22 here. A major reason for irrational behaviour is the existence of information gaps, when we do not have enough information to make the correct choice. This is true for buying a laptop or a car. But we can also be overloaded with potential information, which also makes the task of making the rational decision more complex.

A fourth factor could be the influence of others. This is clearly seen when people often give in to peer group pressure to partake in activities that they normally would not do. While this may not apply to our rip off Britain insurance companies taking advantage of loyal customers, it does have a significant impact on irrational behaviour in the country. Think of the cheeky cigarette walking home from school with your friends, and question whether you genuinely wanted it or not? Would you have smoked it if you had been walking by yourself?

How can we overcome these irrational decisions? There is currently a lot of negative press about loyal customers being “ripped-off” by companies taking advantage of them. But the message does not appear to be getting through quickly enough. Making information available, and more front-page headlines screaming out the news may work, but is it guaranteed to change peoples’ inertia?

Fines for companies that charge higher prices to loyal consumers could be imposed, but firms could easily argue against it, stating that the contract explained what was going to happen after the first year. There is probably no case to argue if the small print that people should read, but never do, is written well enough.

We could then ask the question. Is it the government’s responsibility to seek out and punish a private company that is simply taking advantage of the idleness, the inertia, the inability to compute, of its customers? In a free market, the consumer must have some responsibility for checking that they are getting a deal that meets their needs, that maximises their utility.

Additional activities

“It is a moral obligation, an unwritten duty, of every private company to take every last penny they can off its customers.” Critically evaluate this statement

Should the government intervene to prevent loyal customers facing higher prices than new customers. Justify your answer

Additional information

Rip-off Britain

BBC TV Show

The behavioural insights team

Official website (date accessed 6th October 2019)