In This Review
Lawyers may reign in Washington, D.C., but it is economists who drive the policymaking process. In July 2009, for example, Douglas Elmendorf, the economist who headed the Congressional Budget Office, nearly derailed the Affordable Care Act (also known as Obamacare) when he announced that, as drafted, the legislation would not “reduce the trajectory of federal health spending by a significant amount”—contradicting assurances made by the law’s supporters, who had to scramble to make changes to the bill. Economists also dominate in academia, so much so that scholars in the other social sciences call economics “the imperial discipline,” decrying its tendency to intrude beyond its proper boundaries.
The accusation is on the mark: many economists do believe that they can explain political and sociological phenomena better than political scientists or sociologists. Their confidence reflects a conviction that economics is more mathematically rigorous and better grounded in theory than the other social sciences. According to its practitioners, economics offers not only descriptive analyses of how society operates (determining who is affected by a particular tax, for example) but also normative policy recommendations (such as determining the optimal tax rate).
At the core of mainstream economics is the assumption that people optimize—that they make purchases rationally and otherwise act rationally in making economic decisions, taking into account their preferences and the information available to them. And yet it is safe to say that every economics professor has paused at some point after setting out a theoretical model and said something like, “In reality, people don’t act exactly this way.” As Richard Thaler, a professor at the University of Chicago Booth School of Business, explains in Misbehaving, the standard economic approach suffers from the fact that humans are not what he terms “Econs”: they don’t, or can’t, optimize all the time. Sometimes the decision at hand is simply too complex to be dealt with rationally; other times, people allow what Thaler calls “supposedly irrelevant factors” to affect their behavior. For example, in theory, a person should be no more likely to drink a bottle of wine from his or her own cellar than to go out and buy a new one. After all, the bottle in the cellar can be sold, which means that its consumption involves an implicit cost equal to buying a new bottle. But few people think this way. In fact, the so-called endowment effect, in which people overvalue what they have in hand, influences decisions in a variety of circumstances, even when it should not factor into optimal decision-making.
Humans are not “Econs”: they don’t, or can’t, optimize all the time.
In his absorbing and accessible book, Thaler explains that such irrationalities—not failings but facts of life—mean that the mainstream economic understanding of the world and the policies it suggests can be off the mark. He explores alternative methods of optimization, notably including ways to craft policies that “nudge” people—to use the phrase popularized by Thaler and the legal scholar Cass Sunstein—toward making the decisions they would make on their own if they were acting rationally. Thaler is not alone: the broader field of behavioral science has become trendy among policymakers. In 2014, the Obama administration established a social and behavioral sciences team to devise behavioral-based approaches to policy. When it comes to policymaking, however, behavioral economics can be easily abused. In the wrong hands, it can justify a pernicious form of paternalism under which policymakers shove, rather than nudge, to achieve their desired outcome. Thaler denounces this approach, and it is not his fault that his brainchild can be misused. But it can be, and too often is.
“A NATURAL PROGRESSION”
The Harvard economics professor Raj Chetty recently wrote that “behavioral economics represents a natural progression of (rather than a challenge to) neoclassical economic methods.” But the profession has not always seen it this way. At the start of Thaler’s career, most economists were wary of embracing behavioral economics, whether in explaining how people behave or in formulating policy. In part, their hesitancy reflected a belief that seemingly irrational behavior could be understood as a form of optimization. Consider, for example, a firm that discriminates in hiring. At first glance, such behavior appears to be irrational, as discrimination on the grounds of race, sex, and other such characteristics would decrease profits. But in 1957, Gary Becker, an economist from the University of Chicago who went on to win a Nobel Prize, explained such discrimination by positing that employers might suffer some personal cost from hiring people they dislike. Discrimination could thus reflect an instinct to maximize personal satisfaction instead of profits. To dissuade discrimination, governments could impose a tax on it high enough to change an employer’s decision calculus. (The lay reader might be forgiven for seeing a gray area between “rational” and yet subjective and personal forms of maximization and the kinds of “irrational” factors that are the purview of the behavioral economist, but to neoclassical economists and behavioralists, the dividing line is clear.)
Other apparent market imperfections can also be explained as optimizations. For example, the Nobel Prize–winning economist George Akerlof and U.S. Federal Reserve Chair Janet Yellen have explained why some employers choose to pay employees a salary higher than the going rate: under their model of “efficiency wages,” an employer could rationally choose to pay a higher wage to employees whose effort is difficult to monitor in order to give them an incentive to work hard. After all, an employee caught slacking off would risk returning to a lower-paying job. With such clever adaptations in its tool kit, mainstream economics goes far in explaining the world.
But not far enough. Beginning in the early 1970s, Thaler emerged as part of a small group including the psychologists Daniel Kahneman and Amos Tversky that began to focus on anomalies in human decision-making not easily explained by mainstream approaches. In his book, Thaler describes how the behavioralists have identified a variety of systemic biases in decision-making that prevent people from optimizing correctly. When making decisions, he writes, people are often influenced by psychological factors—how a question is phrased, for example, or whether a choice seems fair or unfair—that can lead them to act in ways that appear to be irrational. He finds that psychological factors matter even in financial markets, where one would expect monetary incentives and the presence of experts to discourage irrational behavior. In fascinating detail, Thaler describes the academic journey that began with these discoveries, generously crediting collaborators and others who have made key contributions to the field.
When making decisions, people are often influenced by psychological factors—how a question is phrased, for example, or whether a choice seems fair or unfair—that can lead them to act in ways that appear to be irrational.
Thaler’s is no longer a lonely journey. Behavioral economics is hot, yielding hundreds of articles in top academic journals and even a new textbook that weaves the subject through the usual introductory coursework for college students. Thaler himself has reached the peak of his profession; he is finishing a one-year term as president of the American Economic Association. And behavioral economics is having its day in Washington; the White House team has a mission “to harness behavioral science insights to help Federal government programs better serve the nation while saving taxpayer dollars.” (In setting up this group, Washington was following the lead of British Prime Minister David Cameron, who put together a similar team a few years earlier, with advice from Thaler.) So far, the White House team has had a modest impact, such as finding ways to help people take advantage of tax-preferred savings vehicles and loan repayment programs.
There is ample room for policy that takes behavioral factors into account. Consider, for example, the Obama administration’s mortgage assistance programs, set up in the aftermath of the 2008 financial crisis to help homeowners and stabilize the housing market. Through early 2015, nearly 4.8 million homeowners had their monthly payments reduced through the U.S. government’s refinancing and loan modification programs. The government calculates, however, that there are hundreds of thousands of additional borrowers who could benefit from the programs but have not yet participated. Some of these people have good reasons for their reluctance. They may be planning to move, for example, and thus do not expect to receive enough savings to compensate for the time and effort it would take to sign up for one of the programs. But others have not signed up because they have succumbed to inertia, don’t understand the programs, or are acting irrationally. The behavioralist approach to policy would look for ways to nudge those potential beneficiaries, leading, but not coercing, them to make the optimal decision for themselves. Done right, such a nudge would impose little to no cost on those people who are already truly optimizing by rationally choosing to go their own way.
So far, nudges have been most successful in encouraging people to save for retirement. Many companies now automatically enroll their employees in tax-preferred programs rather than requiring them to sign up for a plan, a tactic that helps employees overcome the natural tendency toward inertia. Among Thaler’s contributions to this field is a scheme, developed in collaboration with Shlomo Benartzi, a behavioral economist at the University of California, Los Angeles, known as “Save More Tomorrow,” through which employees agree in advance to increase their savings account contributions after future pay raises. By having employees set aside the extra cash only after a pay raise, ensuring that their take-home pay never declines, the policy increases savings while sidestepping employees’ psychological aversion to loss. Of course, participants retain the ability to opt out at any time—and so the policy is a nudge rather than a handcuff.
NOT JUST A NUDGE
For all the benefits of policies that incorporate behavioral economics, there is a serious concern: that policymakers can too easily move beyond nudges to something more forceful, something that reflects their preferences more than those of the people affected. When misapplied, behavioral economics provides an easy cover for policies that mistakenly assume that government officials understand people’s true desires and motivations better than they do. Thaler’s nudges are gentle; when misapplied, however, the logic of nudging can undergird more coercive practices, with significant downsides.
In their analysis of several recent energy regulations, for example, the economists Ted Gayer and W. Kip Viscusi found that paternalism, rather than sound reasoning, lay behind U.S. government decisions to regulate incandescent light bulbs and raise fuel-economy standards for cars and light trucks. Regulators claimed that these regulations were good for consumers because with them, people and businesses would have lower electricity bills and save money on gasoline. In both instances, however, the consumers and firms were likely to understand the tradeoffs involved and would, barring the regulations, have chosen to purchase incandescent bulbs and fuel-inefficient cars and trucks. As Gayer and Viscusi argue, the regulations reflect a behavioralist assumption that consumers are irrational and that their true preferences will be better reflected by choices made by government officials. The mainstream economic approach, by contrast, assumes that consumers have valid reasons for acting as they do and that someone willing to purchase a less energy-efficient light bulb or a gas-guzzling vehicle must value other aspects of what they are buying—the warmth of the light, perhaps, or the power of the engine. This approach is more likely to be correct, particularly when it comes to the decision to buy a fuel-inefficient car or truck. Presumably, consumers and businesses are acutely aware of the implications of their choices for gas costs, especially given that the U.S. government requires new passenger vehicles to come with labels detailing annual fuel costs and other statistics related to fuel economy.
When misapplied, behavioral economics provides an easy cover for policies that mistakenly assume that government officials understand people’s true desires and motivations better than they do.
In neoclassical economics, the usual justification for a regulation is the existence of an externality, a side effect of an action that affects others but that is not reflected in the official cost or benefit of the activity in question. A factory discharging pollution, for example, imposes a negative externality on people in the area. Negative externalities can be offset by a tax: if the proper amount could be calculated, charging the polluting factory for the costs it imposes on others would lead to the socially optimal outcome with reduced emissions. Positive externalities, in contrast, call for subsidies. Subsidizing vaccines, for example, limits the spread of disease, benefiting whole communities.
It turns out, however, that the negative externalities associated with incandescent light bulbs and fuel-inefficient cars and trucks are modest. In these cases, the impact of increased energy usage on pollution and carbon emissions is relatively small, which means that society does not gain much, environmentally, from the regulations. Instead, most of the supposed benefits come from savings for the very consumers who would gladly pay more for the light bulbs and cars or trucks they actually prefer. In justifying such regulations, policymakers make vague references to consumers’ supposed inability to weigh long-term benefits against near-term costs. But that reasoning does little to rescue the misguided policies, which appear to rest on the U.S. government’s belief that people should use more energy-efficient products regardless of their actual preferences. This is paternalism disguised as science. Even worse, misguided proposals can crowd out helpful ones: an excessive focus on issues of marginal impact, such as light bulbs and fuel-efficiency standards, has long sidetracked policymakers from addressing the challenges posed by climate change.
Behavioral economics has influenced not just niche areas such as energy policy but also one of most significant pieces of legislation of the past decade, the Affordable Care Act—and here, too, the results have been mixed. The act’s emphasis on prevention is meant to nudge people toward long-term decision-making. By categorizing most insurance plans according to an intuitive hierarchy—bronze, silver, gold, and platinum—the law aims to provide consumers with choices that differ in meaningful but easily understandable ways. Plans labeled with higher-valued metals have a higher actuarial value of coverage: a bronze plan, for example, covers 60 percent of average health-care costs, whereas a gold plan covers 80 percent. Under behavioralist reasoning, consumers are better off with a limited set of plans than with a more expansive one, as fewer choices reduce confusion and hesitation. In reality, however, many consumers have complained that such limitations force them to choose among plans that are not tailor-made for their needs, which often results in consumers paying for coverage they do not need (near retirees being forced to pay for plans that include pediatric services, for example). To save costs, the act has reduced the size of health-care-provider networks, a move that qualifies not as a nudge but as a burdensome limit on consumers’ choice of doctors.
The policy implications of behavioral economics seem likely to grow as the approach becomes more prevalent. It will be important for policymakers to keep in mind that regulators are only human and are therefore just as susceptible as consumers to poor decision-making. It would be ironic if behavioral economics, with its valid criticism of traditional economic approaches that ignore human frailties, wound up giving rise to a heavy-handed paternalism, contrary to Thaler’s vision, in which government officials eschew sound policymaking under the guise of correcting imperfections.