Friday, April 6, 2012

Behavioral Economics and Regulation

Back in 2008, Cass R. Sunstein wrote a book with Richard Thaler called Nudge: Improving Decisions About Health, Wealth, and Happiness. The focus of the book was to discuss how to take findings from behavioral economics and apply them to affecting behavior. Thus, since President Obama appointed Sunstein to be the  Administrator, Office of Information and Regulatory Affairs, Office of Management and Budget, there has been considerable interest to see how he might put this approach into effect. In the Fall 2011 issue of the University of Chicago Law Review, Sunstein, has written "Empirically Informed Regulation," which discusses his approach and a selection of the policy results.

Sunstein starts this way (footnotes omitted): "In recent years, a number of social scientists have been
incorporating empirical findings about human behavior into economic models. These findings offer useful insights for thinking about regulation and its likely consequences. They also offer some suggestions about the appropriate design of effective, low-cost, choice-preserving approaches to regulatory problems, including disclosure requirements, default rules, and simplification. A general lesson is that small, inexpensive policy initiatives can have large and highly beneficial effects." Here are a few examples of the issues and possibilities that he raises for such an approach:

  • "In the domain of retirement savings, for example, the default rule has significant consequences. When people are asked whether they want to opt in to a retirement plan, the level of participation is far lower than if they are asked whether they want to opt out. Automatic enrollment significantly increases participation."
  • "For example, those who are informed of the benefits of a vaccine are more likely to become vaccinated if they are also given specific plans and maps describing where to go. Similarly, behavior has been shown to be significantly affected if people are informed, not abstractly of the value of “healthy eating,” but specifically of the advantages of buying 1 percent milk as opposed to whole milk."
  • "When patients are told that 90 percent of those who have a certain operation are alive after five years, they are more likely to elect to have the operation than when they are told that after five
    years, 10 percent of patients are dead. It follows that a product that is labeled “90 percent fat-free” may well be more appealing than one that is labeled “10 percent fat.”"
  • "In some contexts, social norms can help create a phenomenon of compliance without enforcement—as, for example, when people  comply with laws forbidding indoor smoking or requiring the buckling of seat belts, in part because of social norms or the expressive function of those laws."
  • "Many people believe that they are less likely than others to suffer from various misfortunes, including automobile accidents and adverse health outcomes. One study found that while smokers do not underestimate the statistical risks faced by the population of smokers, they nonetheless believe that their personal risk is less than that of the average nonsmoker."

The wave of behavioral economics research seems to me one of the most intriguing and fruitful developments in economics in the last few decades.  However, in thinking about its value as a method of improving regulation, I often find myself feeling skeptical. Although there is much to praise in Sunstein's essay and approach to regulation, let me focus here on raising four skeptical questions.

1) How big a deal is this combination of behavioral economics and regulation?

The work on how people's savings patterns are affected by whether they face a default rule seems to me the shining success of behavioral economics as applied to policy. It addresses an issue of first-order importance that cuts across macroeconomics, microeconomics, and social policy: Why do so many people save so little? 

However, a number of the other applications seem to me relatively small potatoes. For example, at one point Sunstein lists nine examples of regulations that have been simplified or eliminated. If you add together his estimated cost savings for all nine rules, it's about $1 billion per year. I'm in favor of saving that $1 billion each year! But in the context of federal regulation and the U.S. economy, it's not a large amount.

2) Does behavioral economics imply more regulation, or just offer suggestions for better regulation?

Sunstein clearly takes the second position: "An understanding of the findings outlined above does not, by itself, demonstrate that “more” regulation would be desirable. ... It would be absurd to say that empirically informed regulation is more aggressive than regulation that is not so informed, or that an understanding of recent empirical findings calls for more regulation rather than less. The argument is instead that such an understanding can help to inform the design of regulatory programs."

3) How well can the government apply these lessons?

There are reasons to doubt how well government can apply these insights as it goes about its regulatory tasks. As Sunstein writes: "It should not be necessary to acknowledge that public officials
are subject to error as well. Indeed, errors may result from one or more of the findings traced above; officials are human and may also err. The dynamics of the political process may or may not lead in the right direction."

Consider for a moment a seemingly simple policy, like improved disclosure requirements. What rule should be followed. Here's how Sunstein phrases it:  "Disclosure requirements should be designed for homo sapiens, not homo economicus (the agent in economics textbooks). In addition, emphasis on certain variables may attract undue attention and prove to be misleading. If disclosure requirements are to be helpful, they must be designed to be sensitive to how people actually process information.
A good rule of thumb is that disclosure should be concrete, straightforward, simple, meaningful, timely, and salient."

Just how to apply this perspective in the case of say, the USDA food pyramid or health warnings on cigarette packages or public information on toxic chemical releases is not going to be straightforward. It made me smile that at the back of Sunstein's paper, there is an appendix about "open and transparent government" that takes 12 pages of bureaucratese to explain what the term means.
 Disclosure requirements and other regulations are going to be the subject of intense lobbying, and there will be pressure from many parties to make people feel as if their politicians are being public-spirited and responsive, while continuing to conceal relevant costs and tradeoffs. 

4) Is overcoming these issues unambiguously beneficial?

An often-unspoken assumption in this literature is that people are always better off if they have better information, or better disclosure rules, or a more accurate perception of risk. This isn't necessarily so.  For example, a recent working paper by Jacob Goldin at Princeton's Industrial Relations Center tackles the issue of "Optimal Tax Salience."  The paper is technical, but under the math is a basic intuition: if people are unaware that their marginal tax rate is rising, then they will not cut back as much on work effort. In that narrow sense, the costs of higher tax rates would be reduced. Goldin makes a case that having a mixture of taxes that are more and less salient may actually end up being better for society.

There's no reason government shouldn't be able to learn from the management and marketing literature about how to affect people's behavior. If government is going to impose a regulation, it should be designed to work better rather than worse. And yet, the point of departure of behavioral economics is that people don't always know very clearly what they want. People are affected by how questions are framed, by what information they have, by default rules, by how risks are perceived, by whether costs and benefits are immediate or long-term, and by social norms. Most of us recognize that private sector actors try to manipulate our decisions through these factors, and we are rightly skeptical that  they are doing so in our own best self-interest.

Thus, I find that I tend to be more comfortable with clear-cut government actions, like readily apparent taxes and subsidies, regulations that set certain standards or forbid certain activities, or default rules where the possibility of opting-out is clearly stated. There is some virtue in having government be clunky and apparent in its actions; conversely, a government that views its task as to be more subtle and manipulative, affecting choices in ways that people can't easily perceive, seems to me a potential cause for concern. For example, I'm more comfortable with a tax on gasoline or on carbon than I am with government attempting to discourage fossil fuel use by providing the public with what some government agency has decided is the relevant, meaningful, timely, and salient information.