The Policy Implications of Behavioral Economics :

Richard H. Thaler

University of Chicago

Assumptions of Behavioral Economics

• Humans vs. Econs• Bounded Rationality

– In the standard economics model agents are as smart as the smartest economist, or even as smart as the smartest economist thinks he is.

Assumptions of Behavioral Economics(cont.)

• Bounded Willpower

– Homer Simpson, when told by a gun shop owner that there is a five day waiting period to buy a gun: “Five days, but I am mad now!”

Assumptions of Behavioral Economics(cont.)

• Bounded Self-interest– Economics assumes that agents are unboundedly

unscrupulous.– But,

Assumptions of Behavioral Economics(cont.)

• Bounded Markets: when do “limits of arbitrage” prevent markets from working perfectly?

Are Markets Efficient?

Where does this leave us?

• We are more like homer economicus than homo economicus, and markets are not perfect.

• What then is the appropriate role for government, keeping in mind that those in the government, are also Humans?

Goals and Objectives

• Apply the techniques of the psychology of decision making and behavioral economics to improve decisions without limited choices.

• Offer an approach new approach to public policy that is neither left nor right.

One Approach to Policy:Libertarian Paternalism

Both terms are currently unpopular (at least in the US), and seemingly contradictory. But, neither concept should be controversial:

– Libertarian: protect the individual’s right to choose

– Paternalism: do what you can to improve the welfare of people

And it is possible to achieve these goals with better choice architecture.

Choice Architecture

Anyone who designs the environment in which people make choices is a choice architect

– Menus

– Store layouts

– Government

What is the alternative?

Choice architects must choose some set of institutional arrangements. What design should planners pick?

Example: cafeteria menu planning—in what manner (order, salience..) should the food be presented?

– The plan that make participants better off?– The options that make the participants worse off? (e.g.,

fattest?)– Random?– The options that make the director best off?

Note that some choice has to be made.

Making School Lunchrooms Smarter

• An initiative backed by Michelle Obama •One school in upstate New York was able to increase consumption of salads by close to 300% by simply moving their salad bar near a natural bottle neck in the check-out line. •Another school increased fruit sales by 105% by moving the apples and oranges into a well-lit and attractive basket.

•http://smarterlunchrooms.org/

Most Famous Nudge

Detail of Fly Painted on Urinal

Results: 80% less “spillage”

Principles of Good Choice Architecture

• Defaults

• Expect Error

• Give Feedback

• Understand Mappings

• Structure Complex Choices

• Incentives

Defaults as Nudges

• Organ Donations Opt in vs. Presumed Consent

– Upside—few opt out

– Downside—more families object

– Solution: Prompted choice.

– Update: I-phone App.

Retirement Savings

• Changing the default in 401(k) plans speeds enrollment.

• But many participants blindly take the default saving rates and investment options.

• Best to have good default investment strategies that automatically rebalance.

• Solve the saving rate problem with Save More Tomorrow.

Obama Executive OrderFrom WSJ Tuesday January 18, 2011

• We are seeking more affordable, less intrusive means to achieve the same ends—giving careful consideration to benefits and costs. … This means using disclosure as a tool to inform consumers of their choices, rather than restricting those choices. And it means making sure the government does more of its work online, just like companies are doing.

RECAP: Electronic Disclosure as a new form of Regulation

• Electronic, downloadable information.

– Price formulas

– Personal usage information

• Applications

– Credit Cards

– Mortgages

– Cell phones

Example: Wireless Calling Plans

• At least once a year wireless plans would be required to send a file to every customer with price and usage data.

• Price data would include anything that can incur a charge, e.g., number and minutes of calls by time of day, to most frequent callers, downloads, texts, late fees, etc. Usage data would be the same.

• Users would upload this information to web sites and/or sign up for the sites to monitor for updates.

Advantages of this approach

• Disclosure is an alternative to the continuing battle to regulate credit pricing terms that turns into a game of whack-a-mole.

– In Australia where rates charged to merchants were regulated, new fees are emerging.

• Disclosure allows for innovation since it does not forbid new financial products.

Recipe for Disasters

• Three ingredients from the financial crisis:

– Rare events ("Black Swans") neglected because of overconfidence

– Complex technologies (Black Boxes)

– Counterparty conflicts of interest

Black Swans

• We keep observing things that "cannot happen".– October 19, 1987

– Long Term Capital Management

– Internet Bubble

– Quant hedge fund mini-crisis August 2007

– Financial Crisis 2008-?

• At what point do we decide we have the wrong model?

Arthur Leff: Swindling and Selling “Grey Boxes”

• Ponzi schemes need an answer to the question: how are we making the money? The mechanism need not be very plausible upon reflection, but it must be possible, publicizable and complicated. It cannot be a black-box, but it cannot be transparent. It needs to be a grey box, somewhat understandable, but not so much so that it can be seen through.

• The grey box must be believable and unbelievable at the same time – it has to be understandable that some people will not want to invest in it. … since not everyone will believe in the grey box, the conman must incentivize investors with a higher rate of return. This explains why he is willing to share his monopoly profits.

Grey Boxes on Wall Street

• Calvin Trillin Hypothesis: "The financial system nearly collapsed because smart guys had started working on Wall Street".

• "Hot traders". Since Nick Leeson, who destroyed Barings, we have seen firms unable to distinguish luck from skill.

• Bob Rubin, co-chair of Citigroup, said he had never heard of the term "liquidity put" until the firm lost $50 billion on them.

• Bernie Madoff. $65 billion in grey boxes. Many investors thought he was front-running.

Complexity for regulators

• Fact about SEC professionals

– 1400 lawyers

– 25 Ph.D.'s in economics/finance

– How many hackers?

Counterparty Risk

• Alan Greenspan’s mea culpa: “Those of us who have looked to the self-interest of lending institutions to protect shareholder’s equity (myself especially) are in a state of shocked disbelief. Such counterparty surveillance is a central pillar of our financial markets’ state of balance. If it fails, as occurred this year, market stability is undermined.”

Oil Spill Black Swans

• Tony Hayward, BP CEO "This was a one-in-a-million chance”

• 15,000 wells drilled off North America and in the North Sea from 1980 to 2006.

• 11 activated blowout preventers to prevent a spill. In only six of those cases were the wells brought under control. Fail safe = 45%!

• And if he means 1 in a million per well per year accidents are likely.

Complexity at Sea

• A Coast Guard inspector at a Congressional hearing “The pace of technology has definitely outrun the regulations.”

Counterparty Conflicts of Interest

• Deepwater Horizon was a joint effort among BP, Transocean and Halliburton.

• “Of the 126 people present on the day of the explosion, only eight were employees of BP. The interests of the workers did not always align.

Solutions?• One trap is to conclude that we need to give

lots of power to regulators.

• But if the CEOs of these companies did not understand what was going on, what hope is there for regulators?

• One goal: improve disclosure enough to impose market discipline while still allowing companies to make money.

• In some cases, disclosure to outsiders will improve disclosure inside the firm.

Risk Taxes

• Tax banks who impose systematic risk and drillers who impose environmental risk.

• How to measure the risk?

• One possible approach: require risk takers to carry insurance with large deductibles.

• Question: is the insurance industry up to the job?