Section 1 – Introduction
Believed to be rational creatures, humans have shown time and again that the classical economic representation of their behavior is not the true picture. That is, they do not follow the logical decision-making process which is expected of them – the process that will direct them to choose the most optimal outcome. Instead humans tend to react in ways based on their previous experiences, and choose certain outcomes above others. This can be attributed to their limited cognitive abilities and problems of self-control. Ariely (2009) suggests that this behavior is the actual ‘invisible hand' behind decision-making, instead of what Adam Smith had suggested in regard to rationality. This deviation has been widely studied and is known as behavioral economics. It is a clash of psychology and economics, and the theories under it continue from where the latter two disciplines leave off.
The motivation behind this paper is to study this irrational behavior of humans in the context of energy consumption. Although, consumers have been made aware of the depletion of natural resources and the growing threat of global warming, many of them are not showing any reduction in their energy consuming habits. In fact, by 2040 energy consumption is suspected to grow by 28 percent, and about three-quarters of it will still come from natural gas reserves (EIA, 2017). These statistics show the presence of an energy efficiency gap in today's world, and a part of that has to do with consumer habits.
The layout of this paper includes a brief description of this gap (Section 2). It is followed by a detailed discussion of various behavioral irregularities that explain consumers contribution to this gap (Section 3). Finally, Section 4 draws a conclusion from all the discussions made in this paper and advises on any future research that may be useful.
Section 2 – The Energy Efficiency Gap
‘Efficiency' can be defined as a completion of a task or the achievement of an outcome with an overall reduction in the amount of resources that are used in the process. These resources can be in the form of time, space, material, etc. In the case of Energy, this efficiency avoids the wasteful habits of the past, and attempts to provide the same level of service with reduced non-renewable resources (fossil fuels) but increased renewable resources (air, water, sunlight). It also, hopes to cut down on future costs and promote carbon dioxide abatement.
Alcott and Greenstone (2012) refer to this as a ‘win-win' opportunity for the government. By promoting energy efficiency, they can ensure the welfare of the environment (reduced CO2 emissions) as well as encourage consumers and producers to invest in more energy saving technologies. The correction of the second problem is necessary in order to avoid the creation of an energy efficiency gap. Jaffe and Stavins (1994) explain this gap by posing a question to the reader, about the increased knowledge of the benefits attached to various appliances , but the small uptake of them – why the difference? The answer to this is believed to lie in three completely separated phenomenon's: “(1) market failures, (2) behavioral effects, and (3) modeling flaws,” (Gerarden et. al, 2015).
Levine et. al (1994) conducted a thorough analysis of the existence of the market failures in energy efficiency markets. They began with the argument that once it has been established that the gap is not owing to hidden costs, time lags or parameter specifications only than should market failures be considered. A detail study of four products are done – fluorescent lamps, refrigerators, computers and color televisions - in relation to the four market failures identified in the paper (missing information, consumer decision making, “transaction costs, and capital market imperfections.”). The results show that with other problems non-existent all four products face a form of market failure which needs to be corrected to reduce the gap.
Stavins (2013) attributes modeling flaws to five categories . It is believed that any miscalculation of those parameters can result in an inaccurate measurement of the gap, which in turn can feed into market failure.
As for behavioral effects, the next section goes into detail about it. I employ the use of various behavioral anomalies to explain how our day-to-day choices contribute to the energy efficiency gap.
Section 3 – Behavioral Economics and Energy Efficiency
Each sub-section will attempt to describe a behavioral tool, provide an empirical example, and conclude with any possible solution to help reduce the effect of the tool on the gap.
3.1 Status Quo Bias and The Default Option:
Consumer's seem to prefer to stick to the current state of affairs (or select the default option given by the provider), regardless if it is the most optimal choice or not. This preference is known as the status quo bias. Fredericks et al. in their 2015 paper, use this bias and default as two of the various behavioral economic tools in explaining the contribution of household energy use to the energy efficiency gap. They believe that although these procedures do minimize risk, overall, it stops individuals from receiving the benefits from other better options, that may even offset the particular risk involved.
Their paper goes ahead to quote the work of Hartman et. al (1991), who calls the status quo bias an ‘economic irrationality' on the part of the consumers. Instead of updating/maximizing their utility through the selection of an optimal bundle, as basic economic theory suggests, consumers stick to whatever they deem familiar. Hartman et. al (1991) use this idea and tries to see the effect of the status quo bias on “consumers valuation of the reliability of residential electrical service.” They see the presence of a kink in the utility where the status quo effect takes an existence. This means that consumers are assigning a higher value to their current service over others, even if the other service is claiming to provide lowered prices.
An empirical example of the default option is found in Ebeling and Lotz (2015), in which the authors ran an RCT, in Germany, on two groups of consumers who were either provided with the ‘green electricity' option as a default or had to opt in on their own. The sample size was large (45,921 households), therefore representative of the population at hand. The results showed that 69.1 percent of those who were provided with the default option stuck with it, whereas 7.2 percent of those who had to opt-in, did so.
Both of these studies seem to suggest that consumers will be more likely to participate in energy conserving activities if they are familiar to the service or are suggested to take up a certain option by their provider. This is regardless of the information they may have on the benefits of energy saving behavior. Dodd (2015) suggests three approaches to deal with this problem: (1) Presenting the status quo option, to the consumer, as a loss; (2) along with the loss faced by consumers sticking to the status quo, telling the consumers about the little risk they face if they choose to switch over to the new product; and (3) Story telling. If consumers are presented with stories about those with similar backgrounds, that have in fact gained from the switch to new product, they may be more willing to take it up.
3.2 Loss Aversion
In general, people will more greatly feel the disappointment attached to a loss than the joy that comes with a gain. It is especially true if there is some sort of risk involved (Gal, 2006). This phenomenon is known as loss aversion. Greene (2011) agrees with Tversky and Simonson's (1993) view about loss aversion, that it is based out of the idea of context-dependent preferences. This means that a person having already faced a particular situation may recall the solution or preference they took up in that moment and apply to situation at hand; in this case that situation applies to a past risk or loss involved that is similar to the one in the present.
Another discussion that is brought up in Greene (2011), is the belief that these context-based preferences are placing hurdles in the way for welfare economics . To explain this, the author provides a brief example of “an energy efficient durable good' which offers an equal chance of a gain ($1500) or a loss ($1000). Now the consumers, depending on their status quo, decide against purchasing the good. If, however, they are forced by government efficiency standards to purchase this good, consumers will have to decide whether they would like to adjust their status quo or not and either get a positive or negative ‘net welfare effect', respectively. That is completely up to the consumer and their reference point. this decision on how to view consumers evaluations of the outcome of their energy-saving purchases is the welfare paradox.
Another example of the contribution of loss aversion to the energy-efficiency gap is described by Gillingham and Palmer (2014) . When purchasing a vehicle, consumers face the option of getting a fuel-efficient one. There may be uncertainties attached to this purchase. On top of that, if consumers have a tendency to be loss averse their weight they assign to the payoff may be even heavier. Thus, they opt out of purchasing the more expensive but energy-saving vehicle.
Being loss averse is a very common human behavior, and so Fredericks et. al (2015) suggests that while promoting energy efficient products, messages should be more ‘loss-framed' than ‘gain-framed.' Puri (2016), agrees with this, and presents a two-step solution to this marketing woe: (1) The seller must understand how a consumer's ‘loss aversion' really works. That is, they must be able to pinpoint what their customer does not want to lose; and (2) once that has been established they need to design their marketing strategy in such a way that they provide a solution to this loss aversion. Most consumer worries lye in their budgets, thus framing a message about energy consumption that shows the money they are losing to their current habits will hopefully encourage them to make a switch.
3.3 Risk Aversion
Similar to loss aversion, majority of people are risk averse. That is, they would rather take up an option with a lower payoff than one with a higher payoff. The difference lies in the uncertainty attached to it. Grant (2013) refers to this behavior as being ‘prevention focused' . That is, they rather keep things moving the way they are, and as a result reducing chances of facing any loss. Another aspect of this phenomenon, is the actual amount at stake. Fredericks et. al (2015) talk about the ‘peanuts effect' under which individuals are less likely to be risk averse. They believe that by lowering the stake, there is a higher chance that the gamble will be taken up.
Farsi (2010) provides an empirical example of this behavior and its impact on installment of “energy-efficient systems in rental apartments.” The Random Utility Model (RUM) is put to use in this paper. RUM's are used in situations where there is a need to model the choices amongst substitutes. In this case, with stated preferences, the RUM will help with developing individual utility functions, and in the process examining how risk averse the individuals are in their choices. The author in his conclusion rejects the null hypothesis (i.e. risk-neutral attitudes towards such technologies). It was observed that the risk premium involved, with such a monthly investment, is large, even if the actual risk is relatively low. Proving that those risks that are a result of not being informed (as many consumers were mostly uneducated about these technologies), can also play a major role in the take up of a certain product.
The conclusion drawn from this study, again, suggests the need for better promotion strategies along with a better understanding of a consumer's risk aversion. Instead of providing information on the amount people will save, it would be wise to enlighten them with the benefits associated with such systems. Furthermore, the energy-efficient example above showed that people are also not knowledgeable about these products, this adds onto their risk-averse attitudes, and pulls them away from investing in this area. Making them more mainstream will reduce the uncertainty surrounding them, and will help in their take up.
3.4 The Endowment Effect
Once a consumer owns a product, or has received a specific service, they tend to place a higher value on them. This is known as the endowment effect. It has been suspected to arise from our evolutionary past, in which giving up our possessions was quite difficult. It was seen as risky (Brosnan and Jones, 2012). Pollitt and Shaorshadze (2011) refer to this as a consumer's ‘reference point.' That is, regardless of the wealth a consumer holds and the prices of products, they would not take up the optimal bundle, instead opt for things that are a part of their current endowment and consumption.
Khaneman, Knetsch and Thaler (1990), ran an experiment using coffee mugs to better explain this effect. They randomly divided a group of participants into buyers and sellers (giving the sellers the mugs for free). At the time of assigning valuations to the mugs, it was seen that the sellers valued the mugs at a price double that which was offered by the buyers. Showing that they were not so eager to let go of the mugs. This result can be applied to the purchase of energy efficient irrigation pumps that most farmers opt out of in developing countries (Never, 2014). The author believes that farmers are unwilling to let go of their old systems, mainly due to their attachment to it (endowment effect).
This observation on farming equipment replacement is also applicable to all other energy efficient products, and so Sullivan, Armel and Todd (2012), offer a solution to this problem. In order to detach a consumer from their current product, one must incorporate it into the advertisement for the new product. By presenting the loss associated with the current product, a producer may be successful in selling the new more energy efficient product. This is very similar to the suggestion made under loss aversion. It is only because consumers choose not to relate the product they own with loss, and thus it must be shown to them. The authors also suggest that sellers look out for a time when the endowment effect is not present in a consumer's life. That is, a consumer is more willing to try out a new product when the certain attachment from their life is removed. In this case, a good time would be when they are willingly on the look-out for new technology.
3.5 Time Inconsistency
When viewing something in the far-off future as less valuable compared to something much closer in time, regardless off its real value, a consumer exercises their characteristic of being time inconsistent. Behavioral economists refer to this phenomenon as hyperbolic discounting, in which the future is discounted much lower than the present. This leads to attitudes of delayed activity, complete inaction and reduced cooperation amongst consumers (Fredericks et. al, 2015).
Wada et. al (2012) presents an empirical example of this anomaly, in which they look at the role played by discount rates when it comes down to the purchase of energy efficient appliances. Specifically, the authors develop a model in which they asses the pay-back period of various energy efficient home appliances. Although it is shown that payback periods, in general, are shorter (6 years) in comparison to the life of an appliance, it will still be observed that consumers will opt out of the purchase. To explain this, they present the results of three empirical studies that look at the discount rate consumers attach to appliances. Varying between 20%-40%, these discount rates are much higher than the internal rate of return (18%), which had been predicted earlier with the payback period model. These studies further concluded that larger discount rates are also associated with smaller, expected, pay-back periods (3-5 years). Thus, it was gathered that the presence of high discount rates would give a smaller weight to future gains obtained from such an appliance in comparison to the current investment being made for the purchase.
Looking at these results it would be wise to suggest that during the moment of purchase consumers be offered a payment alternative, like paying off the amount some-time in the future (or in installments), after some use of the appliance. That future investment would be discounted less than the present benefits of taking the product home. Fuwa et. al (2015) applies this thought on credit institutions, by studying factory workers in the Philippines who are participants of the ‘ATM sangla' program. This program protects lenders, by not allowing disbursement of income through ATM on default loans, and collecting this income until loan is payed back in full. The debit card serves as a ‘pawn' in the loan agreement. The authors first assessed the type of discounter a respondent was (in this case there were three types ), and followed that up by the borrowing habits of each type. The hyperbolic discounters (that made up 1/3 of the respondents) showed a knack for borrowing compared to the other groups, especially for things like medical expenses and other daily needs. To them it seemed that having the money in hand now, outweighed the loss faced in the future in the form of payback. In the same way, having the appliance in hand now – and reaping it benefits – outweighs the loss faced in the future in the form of investment.
A rule-of-thumb or a strategy that persons adopt overtime to aide in making day-to-day decisions is referred to as a heuristic. Gigerenzer and Gaissmaier (2011) believe that in the process of making a decision a human being uses one of the three tools available to them – “logic, statistics or heuristics.” Out of these three, heuristics are considered to be the most irrational as they do not employ a series of computations or complex models to make the final choice, however, it is the tool that is mostly used. This is because humans suffer from “bounded rationality” (Simon, 1955). That means there is a limit to their cognitive abilities which disables them from making completely rational choices.
Andor et. al (2016) highlights this phenomenon, in their empirical research, as one of the reasons contributing to the inattentiveness of consumers towards energy labels. The experiment involves a randomized control trial, in which participants are divided into three groups, differing in the level of detail provided in the energy label of the products that are being sold. Furthermore, they employ four choice sets, which present a spectrum of differences in between products, to try and gauge the participants valuation of the varying attributes. In specification to heuristics, the authors develop a mathematical model which concentrates on choice set III (this has great differences in prices and class but not such high differences in consumption levels). The results show that many of the consumers use these ‘energy efficiency classes' as the basis of their decision, since human nature widely relies on rankings (availability bias) when it comes to decision making in unknown territories. The more rational route would have been to examine the small but significant differences between consumption levels, which a tiny group of highly educated people did adopt, but it was not the norm.
Flynn (2007) believes that if an opinion or thought becomes a widely accepted phenomenon many people will not have an issue in accepting it, and will happily associate with it. This requires less effort on part of the consumer. Although, there has been a great amount of coverage in news outlets and intellectual settings about the need for energy conservation, it has yet to garner enough conversation to infiltrate our decision-making process. Thus, policy makers should make it their sole purpose to alter the norm, or as Reinhardt et. al (2017) put it, “tilt the system.” Changing one's surroundings will force them to eventually adopt it.
3.7 Choice Overload
The idea of ‘bounded rationality' is not only limited to the application of heuristics in decision making, but also plays a major role when there are too many choices (Pollitt and Shaorshadze, 2011). Behavioral economists believe that in this day and age with so many options and brands available to us we are starting to develop a fear towards making a choice and in many cases, end up with things which are not the best for us (Tugend, 2010). In other words, too many choices are pushing us towards irrationality.
Haynes (2009) ran an experiment, using prizes as the choice variable, in order to test this hypothesis. Participants were divided into two groups and given either a limited choice set or an extended one, and then given 2 mins or 10 mins to make the decision on what prize to choose. This time factor was added in to assess the difference in level of difficulty and regret from making a decision in both groups. Other aspects under assessment included task enjoyment and satisfaction. The hypothesis made earlier on had suspected that those with larger choice sets would face more frustration and regret and less satisfaction than the other group. The results agreed with this hypothesis somewhat. The larger choice group were more frustrated and less satisfied, but surprisingly were far less regretful. This group also enjoyed the task a lot more than those with limited choices. An explanation for higher regret in limited choice participants can be attributed to their attachment developed to other prizes that may have also seemed like a good option, but the author suggests further scrutiny of this idea.
The higher difficulty level attached to decision making in the case of more choices, as seen by the prizes experiment, signals to us that a consumer will likely make a less optimal decision in such circumstances. If they already have a certain brand they are accustomed to, then in the case of more choices they will stick to what they know (status quo bias). But in the case of new technology, it would be wise to reduce the choices available in order to direct the consumer into selecting the better product. In other words, producers of energy saving products should promote a single technology and update consumers information in regard to it, in order to increase energy saving habits.
An altruistic person is very selfless and highly motivated to work for the betterment of their society. It is believed that such persons are irrational when it comes to decision making, as they would rather choose an option that would benefit a whole group over simply benefitting themselves. Balter (2014) believes this characteristic arises from the practice of “cooperative breeding” which our ancestors adopted. This practice, in general, looks at the cooperative behavior in between members of early communities when it came to child rearing, but can just as easily be applied to other factions of society. In this case it would be the consumers cooperation in the take up of energy saving habits.
Asensio and Delmas (2015), provide an empirical example of obtaining this cooperation and promoting energy saving habits. By enlightening a group of consumers about the health implications attached to high energy consumption levels, they were hoping to see consumers partially curb this habit. Over the study period participants were provided with either information on savings they made in energy consumption as compared to their neighbors or data on their weekly contribution to air pollution and its health effects on the community. The difference in these methods lay in their approach – one was self centered and the other aimed to show a user's negative contribution to the society. It was seen that those who were provided information that was self-centered actually increased their consumption levels. Whereas those who were now informed about their contribution towards air pollution decided to cooperate and reduced their consumption levels on average by 8.2 percent.
It seems to be that altruism, unlike other behavioral anomalies, serves to reduce consumer energy consumption. Thus, a simple solution would be to adopt such marketing strategies that motivate a consumer to be more cooperative towards reducing the energy efficiency gap through their consumption. Producers are finally catching on to the need of pro-humanity promotion. Wegert (2016) relates the story of Japan Airways and their successful advertisement with the message of world peace. She reports that not only are these sorts of ads a great way to boost a company's PR, but consumers are also wanting producers to take part in wellness campaigns . In the case of energy efficiency, the involvement of the supply side in pro-environmental behavior will add to their credibility and will make it much easier for them to encourage consumers to do the same whilst making purchases of energy appliances and services.
Section 4 – Conclusion
All anomalies that were described, except altruism, imposed an effect on the decision-making process that was in defense of irrationality. The analysis that was conducted, not only depended on the theoretical definition of these behavioral tools, but also on empirical evidence. This solidified the notion of negative behavioral effects on the energy efficiency gap. The anomaly that showed a positive effect is suggested to be adopted by mainstream producers to help in the reduction of this gap.
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