When Consumers Ignore Risk

Risk spirals and collective ignorance

Increasingly risky subprime borrowing, rise in the number of botched plastic surgeries carried out in uncertified facilities, and once highly reliable home appliances breaking down sooner… these are examples of products and services becoming increasingly risky over time. Why and how do these increasingly risky products become the norm?

According to common wisdom, large scale buildups of risk in markets, such as the subprime mortgage crisis, are outliers. They are “black swan” events, or “perfect storms,” resulting from unlikely and unlucky combination of events. In their recent JCR paper, Léna Pellandini-Simányi and Michelle Barnhart argue instead that risk buildups are the natural course of markets in which (1) product risks are difficult to assess, (2) risks take time to materialize, and (3) products can be made more affordable by increasing their risk.  In these markets, consumers become less attentive to risks over time, while producers are prone to offer increasingly riskier alternatives. Unless regulators and opinion leaders intervene, the market enters into a spiral of increasing risk.

How do these risk spiral develop? Consumers are often suspicious of new products. According to the model developed in the paper, early adopters tend to be more highly educated, such that they are able to examine a new product’s risks in detail. New products that are safe enough to withstand this scrutiny are adopted by this group of consumers. Once early adopters start to use the product, other consumers follow. They do not study the risks, but instead assume that the product is safe based on prior adopters’ successful use.

Increasing demand attracts new competitors to the market, who offer new product versions made more affordable by increasing their risk. For example, banks can offer higher risk mortgages, clinics can offer surgeries by less experienced practitioners, and mobile phone companies can offer more poorly made phones.

Late adopters, who assume from others’ use that the product is safe, do not notice the increase in product risks, and choose the cheaper, higher-risk versions. According to the model, at this point, inattention to risks has become commonplace, leading to collective ignorance of risk among consumers.

Rising demand for cheaper versions encourages companies to offer even more affordable, higher-risk products. This leads to even more widespread use, which further reassures new adopters of product safety. These dynamics mutually reinforce one another, creating a risk-spiral—until the risks materialize.

Risks may materialize as a full market collapse or only for some consumer segments. In either case, the harms are not equally distributed across society. Early adopters tend to be of higher socioeconomic status, while late adopters, who purchase only after the product has become more affordable, tend to be of lower socioeconomic status. Because risk increases over time, early, high socioeconomic status adopters purchase safer products than later, lower socioeconomic status adopters do. Therefore, the most vulnerable consumers end up with the highest risk products. In the case of financial products, like the home mortgages examined in the research, the poorest, least educated consumers acquired the highest risk products – which contributed to making the poor poorer and the rich richer.

Can risk spirals be prevented in markets with these characteristics? Yes. Effective regulation could prevent risk buildup. In addition to implementing the typical information disclosure requirements, regulators could intervene by controlling and curbing product risk. For example, they could impose product safety and suitability standards. These types of measures are more likely to protect consumers than required information disclosure and financial literacy programs alone—which have little effect once consumers assume that a product is safe because “everyone” is using it. Even highly financially literate consumers can succumb to the reassurance of safety provided by the herd and ignore risk information. Possible counters to the effect of the herd are the media and opinion leaders, who could help to draw attention to risks.

The article The Market Dynamics of Collective Ignorance and Spiraling Risk by Léna Pellandini-Simányi and Michelle Barnhart can be downloaded here https://doi.org/10.1093/jcr/ucae018

The research received funding from the Swiss National Science Foundation and from OTKA Hungarian Research Finds. For inquires please contact Léna Pellandini-Simányi at pellal@usi.ch or Michelle Barnhart michelle.barnhart@oregonstate.edu.