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The Possibilities of Behavioral Economics

Just how rational are we? That’s the question at the heart of behavioral economics, an intellectual movement boasting hundreds of professors around the country and more than a few policy makers in the Obama administration.

The movement extends back to the mid-1950s, when several economists and psychologists began to question the so-called “classical” economic model of how people made decisions. In general, this model said, people were rational and therefore they acted, economically speaking, in their own best interest.

Clearly, many psychologists noted, people do not always act in their own best interests, economically speaking or otherwise. In many cases, they don’t even act in accordance with their own stated preferences. Why, then, should economists use the “classical” model when trying to explain or predict economic behavior? Wouldn’t it be better to assume irrationality? Or, at least, to see what kinds of biases, misperceptions, and faulty reasoning people bring to bear on certain economic decisions, and then make predictions and policy based on that?

Our irrational nature

The recently published Thinking, Fast and Slow, by Daniel Kahneman (Farrar, Straus, and Giroux, 2011), catalogs a number of concepts that demonstrate our tendencies toward irrationality. The Nobel Prize-winning psychologist’s research laid the foundation for behavioral economics and continues to be influential today. The book includes some familiar concepts recognized in a number of fields, such as:
  • The halo effect. This is the tendency to overgeneralize, particularly in cases of physical attractiveness. For instance, when we find an aspect of someone attractive, we tend to project other unrelated attractive traits on to them. Ken is good looking and amiable, one reasons, so he must be smart, too. It also works in reverse, as when one observes rudeness and concludes that the perpetrator is also callous, arrogant, and cruel.
  • Sunk cost fallacy. This is the inclination to make an economic decision on the basis of past investment instead of future possibility. When faced with a repair that costs more than a better car, for example, an owner opts for the repair because he’s “sunk” so much money into the car already.
  • Outcome bias. This concept describes the tendency to judge a decision solely on its outcome. For instance, someone drains her savings account to play roulette, ends up winning big, and concludes that gambling is a good way to manage money.

Kahneman’s list of “irrationalities” and “cognitive biases” and the in-depth studies of other researchers in his catalog clearly demonstrate that human behavior — particularly economic behavior — is very often unpredictable.

Behavioral economics in practice

So how is such knowledge turned into practice by economists or policy makers? In one of two ways, according to Oren Bar-Gill, professor at New York University (NYU) School of Law:
  1. Altering communications (or “disclosure”) so that recipients — normally, consumers — are more likely to be adequately informed about an economic decision, and
  2. Setting “defaults” so that a preferable choice is more likely.

Knowledge

According to Bar-Gill, a good example of improving communications tools is the Federal Reserve Board’s new credit card disclosure rules. Research shows that consumers routinely came to incorrect conclusions about credit card fees and fines, even after reading cardholder agreements. So the Federal Reserve Board, drawing on current research, wrote new guidelines for disclosures that are designed to help consumers make fully informed choices about credit card use.

Changing employee 401(k) participation guidelines is a classic — and, most behavioral economists would say, successful — example of changing a “default” rule to encourage a particular behavior. Before 2006, nearly all companies that offered an employee a 401(k) plan did not automatically enroll them. The “default” mode, in other words, was “opt-out,” so employees had to conscientiously sign on to the program. After legislation was passed that protected companies from most litigation, many switched to a default “opt-in.” The number of 401(k)s went from around 70 million in 2006 to over 80 million in 2010  — proving, according to behavioral economists, that a little default-setting can achieve a lot of good.

The appointment of Cass Sunstein to administrator of the Office of Information and Regulatory Affairs (OIRA) has put behavioral economics at the center of federal policymaking. An author of numerous articles on behavioral economics and co-author of Nudge: Improving Decisions About Health, Wealth, and Happiness (Yale University Press, 2008), Sunstein has committed the OIRA to ensuring disclosure policies that “promote informed choices” and “sensible default rules” that help obtain “important social goals.”

The Federal Reserve Board’s new credit card disclosure rules are one example of behavioral economics making its way into policy. Another comes from the Federal Communications Commission, which recently pressured the country’s largest wireless and cell phone companies to adopt guidelines that compel them to notify users of potential extra charges. The hoped-for results: fewer complaints about “bill shock” because of hard-to-know fees and rates, and more consumers buying plans that best fit their actual usage patterns. Similarly, the Consumer Financial Protection Bureau (CFPB) is researching and developing better designs for the mortgage disclosure documents it will use in its “Know Before You Owe” program.

Dozens of other policies have been proposed by behavioral economists. Richard Thaler and Sunstein, for example, want to reduce health care costs by giving people the freedom to waive the right to sue their doctors in exchange for lower fees. They also advocate changing the organ donation default from “presumed refusal” to “presumed consent” when registering for a driver’s license. Knowing that people have a tendency to favor the first option presented to them, a trio of behavioral economists, writing in the book New Perspectives on Regulation (The Tobin Project, 2009), suggest making it mandatory for lenders to present a standard, fixed-rate mortgage before discussing other options with potential homebuyers. They also suggest that income tax refunds for low-income filers be automatically deposited into a standard bank account as a way of steering money away from payday lenders and their high fees.

Bar-Gill is confident that the use of behavioral economics has been and will continue to be beneficial. He was drawn into the field when he noticed significant differences between studies of business-to-business contracts and business-to-consumer contracts. “You could accurately predict outcomes of business-to-business contracts using classical economic theory, but not business-to-consumer contracts,” he says. The reason: businesses — or, more accurately, business lawyers — are on a level playing field with each other in terms of information and sophistication, while consumers are at a disadvantage and thus often made less-than-optimal choices. The promise of behavioral economics, he thinks, is that “through better disclosure rules and default options, consumers will make better choices.”

The counterpoint

Behavioral economics has its critics. Some have questioned its basic terminology: are “rational” and “irrational” always easy to distinguish? But now that it’s being used explicitly in federal policymaking, many scholars have focused their attention on the view of government that undergirds its application. This view, they say, is essentially paternal. And while behavioral economists like Cass Sunstein and Thaler have cheerfully embraced the “paternalistic” label (with qualifications, of course), their critics insist that political paternalism, even when well-intentioned, is an improper framework when exercising political power.
Behavioral economics has its critics. Some have questioned its basic terminology: are “rational” and “irrational” always easy to distinguish?

Mario Rizzo, associate professor of economics at NYU, is particularly concerned about the paternalistic presumption that policymakers know more about what’s best for people than people themselves. Like many critics, Rizzo thinks that behavioral economists are too quick to assign the word “irrational.” “[T]here is nothing per se irrational about placing more weight on the present than the future,” he writes. Those who put off the purchase of health care insurance or spend money on a boat instead of investing it, for example, may not act according to the better judgment of behavioral economists, but their choices are not for that reason wrong, irrational, or foolish.

Nor is it always “irrational” to say one thing but do another, according to Rizzo. It may seem irrational for someone who smokes to say, “I really want to quit smoking.” In reality, however, people always prioritize their energies, leading them to want something better for themselves but not working for it at that particular time. For a smoker who wants to quit, holding a job (or maybe even finding a job), taking care of an elderly parent, or a host of other things could quite reasonably be prioritized ahead of throwing away the cigarettes.

Likewise, behavioral economists are overly confident in their ability to determine what is good for society at large, says Bruce Hutchinson, professor of economics at the University of Tennessee at Chattanooga. He takes particular issue with the claim that we need different mortgage disclosures or defaults because many people made bad choices to take out loans — especially subprime loans — when housing prices were at their peak. “Were they all bad choices?” he asks. “Many people are perfectly happy with their purchases, which means they benefitted from their choice.” Somewhere between 15–30 percent of all homes purchased with subprime mortgages are in foreclosure — a high number, to be sure, but it means that 70–85 percent of subprime mortgage holders are making regular payments and enjoying the benefits of owning a home. How, exactly, should a behavioral economist weigh the benefits for individuals and society against the harm done by above-average foreclosure rates? “It’s not just hard to do, it’s impossible. There are just too many factors and unknowns to weigh,” asserts Hutchinson.

In his column on Townhall.com (November 1, 2011), Thomas Sowell, a Stanford economist and conservative commentator, makes similar points regarding payday loan companies, another target of policy makers. No third party can know if paying $45 to get a loan a few weeks ahead of a paycheck is a good use of that money. There are good and bad reasons for using such a service, and planners who want to nudge or regulate payday lenders out of business may end up hurting the very people they claim to be helping.

Rizzo concludes that policy makers using behavioral economics can’t say their preferences are better than anyone else’s. “Ordinary people know their personal and local circumstances better than the state and … are probably better equipped to reach their own goals,” he asserts. Government policymaking should adhere to classical libertarian limits, he adds, which means it should aim at preventing legally defined harm, prosecuting misrepresentation, and correcting inherent economic inefficiencies like monopolies.

Hutchinson agrees. “Saying ‘401(k)’s are good for everyone’ is the first mistake in a series of decisions that will only get worse,” he says.

Another “third way”

In their popular book Nudge, Thaler and Sunstein conclude by claiming that their version of paternalism is a true “third way” between (generally Democratic) “enthusiasm for command-and-control regulation” and (generally Republican) policies against government intervention. A different third way, however, has emerged between the advocates of behavioral economics and their critics.

Christine Jolls is the Gordon Bradford Tweedy Professor at Yale Law School as well as the director of the Law and Economics Program at the National Bureau of Economic Research (NBER). She is enthusiastic about behavioral economics, but “hesitant about government setting defaults,” she says. “It’s OK for private companies to do this, but it seems an overreach of government authority.”

Jolls has no concerns, however, about government using results from psychology studies to improve — and even mandate improvements in — the presentation of information. “Many areas of consumer law really need attention,” she says, “and employee manuals often don’t spell out conditions for termination in clear, understandable prose.” She thinks that the work currently being done to make mortgage disclosures more understandable is a good example of using behavioral economics to improve consumer-oriented communications.

Greg Mitchell, a professor at the University of Virginia School of Law, is sympathetic to Jolls’s position. “No one will contest the need for more and better information,” he says, and he thinks that a lot of “important, valid work” has been done in this field by behavioral economists. But he’s also nervous about government-set defaults, partly because they hint of government overreach, but also because “it’s important to give people the freedom to make — and learn from — their mistakes.” He concludes that “behavioral economics has a place at the table,” but he doesn’t think it’s time “to replace one flawed economic theory with another.”

Interestingly, such a position could be described as a “third way” between classical economic theory and behavioral economics. People often act irrationally, to be sure, but they certainly have the capacity to act rationally as well. That seems sensible enough — but who really knows, given the human tendency to think irrationally?

Michael LottiMichael Lotti is a freelance writer and holds a PhD in philosophy from Swansea University in Wales.
Contact Michael at lottiwriting@q.com.

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