Behavioral Economics Part 3

642 PART SEVEN In pu t M arke t POLICY IMPLICATIONS In the other chapters in this last part of the book on market failures, we encountered two possible sources of inefficiency in markets. One was asymmetric information (Chapter 15) and the other was externalities (Chapter 16). In yet earlier chapters we saw that market power can be a source of inefficiency, for example when the monopolist in Chapter 11 restricted output in order to raise price above marginal cost, leading to a deadweight loss. Behavioral economics offers yet another source of market failures: limits to cognitive ability and willpower may lead participants to make the ‘‘wrong’’ decisions in the market. Moreover, sophisticated firms may understand consumer biases and may try to exploit these biases for their own profit. Some behavioral economists use this line of reasoning to argue that the government should play a paternalistic role, intervening in markets to fix participants’ mistakes and overcome other limits to rationality. Some neoclassical economists counter that participants have the strongest incentives and best information to make the right decisions for themselves. They argue that government paternalism has a good chance of increasing rather than decreasing market failures. This is a controversial question in economics, so we will try to present ideas from both sides below. Borrowing and Savings Decisions To take a concrete example, consider decisions to borrow or save. As discussed in Application 17.1, the decision can involve complicated interest calculations and other hard math, which often lead to mistakes. Therefore, limits to cognitive ability may lead to the wrong savings decision, perhaps biasing people to save too little. Limits to willpower also may lead people to save too little because there are tempted by the lure of immediate consumption. Possible government interventions that might help people make the ‘‘right’’ savings decision would be to mandate a savings plan, say requiring people to save a minimum of 15% of their income, or it could subsidize savings, say by exempting interest earnings from income tax, as is done with Individual Retirement Accounts (IRAs) in the United States, discussed in Application 14.1. The government could leave it to people to invest the savings in their own way (stocks, bonds, bank accounts) or could tax them directly and invest the money for them. Governments in effect do this through their retirement programs, including Social Security in the United States. One argument for government interventions such as IRAs and Social Security programs is that behavioral biases lead people to save too little and are better off if forced to save above a certain minimum or have their savings subsidized. On the borrowing side, if people are thought to be led to borrow too much because of calculation mistakes or willpower problems, the government might regulate credit cards, perhaps putting a cap on the number of cards a person can have or the credit limit for each card or requiring a waiting period after applying for a card before it can be used. The government might regulate the level of interest rates or how they are advertised (Truth in Lending laws in the United States.) if people tend to miscalculate interest rates from information on loan amounts and periods as suggested in Application 17.1. CH APT ER 17 Behavioral Economics Other Goods and Services Government interventions in other areas could address the problems raised by behavioral economics. If consumers are thought to be overwhelmed by choices at retail outlets, the government could restrict stores’ offerings or perhaps tax overall shelf space. If irrational choices are leading to overeating, the government could ban or tax high-calorie or high-fat foods. Of course many governments around the world already ban certain narcotics and restrict or heavily tax tobacco and alcohol. Many of the arguments for the government interventions here are paternalistic in nature, based again on the problems identified by behavioral economics. Market Solutions Some neoclassical economists are not completely convinced that research in behavioral economics has proved the existence of limits to rationality. They are not so sure people’s decisions are mistaken in systematic ways that can be improved by government intervention. If one takes this view, then government interventions to influence choices that are not in fact mistakes will lead to deadweight losses, just as price controls and taxes were shown to do in Chapter 9. A less extreme view would be that although people undoubtedly make mistakes, the consequences of these mistakes may lessen over time. People may learn to make better decisions with experience or may seek advice from experienced friends, colleagues, or professionals. People may learn to avoid offers that are ‘‘too good to be true,’’ sticking with the status quo unless one is sure the new opportunity will be a good one or to recognize especially difficult decisions and take special care in making those. Although a bias toward the status quo may not be perfectly efficient, it may provide a fairly satisfactory level of well-being. The market may recognize a profitable opportunity in providing products and solutions that solve behavioral biases. Any of these mechanisms could, over the long term, mitigate the problems suggested by behavioral economics. Whether competition by itself can eventually overcome any behavioral bias or limit to rationality is a matter of recent interest in economics. The model of perfect competition might suggest that products and services that are best for consumers will be produced in the long run, and these will be sold at marginal cost. Good firms will drive out bad firms, and good choices will drive out bad ones. However, there are limits to what competition can do. Different consumers like different things, and a whole range of products and choices may persist in the long run to serve each niche rather than the market converging to one ‘‘right’’ product or choice. In addition, people’s cognitive limitations may make them imperfect shoppers, so firms that offer bad or expensive choices may persist in the market in the long run.12 ‘‘Nudging’’ the Market If the government intervenes in the market with regulations, taxes, or subsidies for paternalistic reasons, it risks being wrong about the underlying behavioral problem 12 See X. Gabaix and D. Laibson, ‘‘Shrouded Attributes, Consumer Myopia, and Information Suppression in Competitive Markets,’’ Quarterly Journal of Economics (May 2006): 505–540. 643 644 PART SEVEN In pu t M arke t and introducing deadweight loss where there was none before. Milder interventions that preserve voluntary choice may help solve behavioral problems with less risk. The government can try to increase the availability of simple information that helps consumers make complicated choices. The government can do this either by supplying the information itself or by mandating that firms provide such information usually in some standard format. This was done in the United States with the Truth in Lending laws mentioned above, one provision of which required lenders to quote annual percentage rates for loans, a simple number that can be used to compare the relative attractiveness of two loans with very different and very complicated terms. Another example is the requirement to display nutritional information in a standard format on the back of food packages. Another mild intervention that can address behavioral problems while still retaining the best features of voluntary transactions is to provide a default choice that is good for most consumers but to allow them to opt for some different option if they so choose. Choice is not restricted, so any deadweight loss from distorting free decisions should be minimized, but consumers who may otherwise have made a bad decision, if they stick with the default option, will end up not doing too badly in the default. An example is provided by defined-contribution retirement plans, 401(k) plans, which firms offer to their employees. When the default was nonparticipation, requiring an active decision to opt into the plans, less than half of employees were found to enroll in a 401(k). When the default was switched to participation, almost all of the employees enrolled.13 If firms are concerned that their employees save too little for retirement, a natural policy response would be to set the default at some moderate level of participation. Those employees with special reasons for saving less can still choose to do so. A recent popular book by two leading behavioral economists suggests that firms and governments should apply the same idea—of ‘‘nudging’’ how choices are presented to highlight ones that might be best for people—in many other spheres besides retirement savings, ranging from offering sensible defaults health plans to arranging food in a cafeteria line so that healthy items are encountered first.14 SUMMARY This chapter provided an introduction to behavioral economics. By integrating the fields of psychology and economics, this growing research area seeks to understand whether and why actual decisions depart from idealized, fully rational ones. Some of the broad insights discussed in the chapter include the following. 13 • Departures from full rationality can be classified in three ways: limits to cognitive ability, limits to willpower, and limits to self-interest. • Cognitive ability may be especially strained when making decisions that involve complicated formulas, uncertainty, an overwhelming number of choices, or multiple steps of reasoning. Experiments B. Madrian and D. F. Shea, ‘‘The Power of Suggestion: Inertia in 401(k) Participation and Savings Behavior,’’ Quarterly Journal of Economics (November 2001): 1149–1187. 14 R. H. Thaler and C. R. Sunstein, Nudge: Improving Decisions About Health, Wealth, and Happiness (Yale University Press, 2008). AQ3 CH APT ER 17 Behavioral Economics have uncovered some systematic biases in these sorts of decisions. • An early, influential behavioral model is prospect theory. According to this theory, people take their current wealth as a reference point and dislike small losses from this point (contrasting the standard theory, which suggests people should be risk neutral regarding small gambles). People with these preferences may make different decisions in equivalent settings when only the framing of the situation is changed. • People with limited willpower may behave inconsistently over time, for example, planning to exercise, study, or quit smoking, but then being unable to stick with the plan when the time comes. We studied the model of hyperbolic discounting, in which people’s decisions are heavily weighted toward their current rather than their future wellbeing. • In strategic settings, people may not act to maximize their monetary payoffs because they may have other interpersonal values such as altruism, fairness, and justice. We studied ways to model these interpersonal values. • Behavioral economics provides a further rationale for government intervention in markets to correct the irrational decisions of participants. Such interventions may harm social welfare if the government misconstrues rational decisions as mistakes. A compromise may be for policymakers to highlight choices that they judge to be good for people but still allow people to freely choose other options. REVIEW QUESTIONS AQ4 1. Describe the three limits to rational decision making identified in this chapter. 2. Distinguish between behavioral and neoclassical economics. What are the relative merits of each approach? Would you expect the relative merits to change as knowledge advances? 3. One oddity often observed in the market is that stores charge prices ending in 99 (so we see prices of $1.99, $5.99, and so forth). Explain why this sort of pricing might be puzzling to economists. Some have suggested that this is due to stores trying to exploit a cognitive limitation of shoppers. What sort of cognitive limitation might this be? Would you expect market forces to prevent firms from exploiting consumers in this or other ways? 4. Behavioral economists have different views of the anomalies uncovered by experiments. Some view the anomalies as evidence of mistakes in decision making. Others view the anomalies as providing a new understanding of people’s true preferences. What difference does it make for policy which theory is right? How could the theories be tested apart using experiments? 5. According to prospect theory, people are very averse to small risks. How is this captured on a utility function? How is this different from the standard theory about choice under uncertainty discussed in Chapter 4? 6. Argue that in the Centipede Game, a player is better off being known to be short-sighted. Are 7. 8. 9. 10. 11. there any other settings in which it would be useful to be known to have behavioral biases? What did Odysseus’s having himself tied to the mast indicate about the level of his rationality? Provide three other examples of commitment devices used in the real world. Distinguish between altruism, fairness, and reciprocity. Suggest experiments related to the Ultimatum Game that could sort out how much each of these interpersonal values matter to subjects. A vast amount of information is available on Internet Web sites free of charge. The Web site author may just be altruistic. Give at least two other motives for Web sites to give away information. Which motives seem to best fit some of your favorite Web sites that give away free information? ‘‘Behavioral economics provides important insights into consumer decisions but not decisions by organizations such as firms or governments.’’ Provide arguments both in support and against this statement. ‘‘Behavioral economics justifies intervention in the market by a paternalistic government.’’ Explain the pros and cons of this view. What other market failures were identified in the book where government intervention might have been called for? Is the argument for intervening to solve behavioral problems stronger or weaker than the argument for intervening to solve these other market failures? 645 646 PART SEVEN In pu t M arke t PROBLEMS 17.1 A queen gives a dragon-slaying hero a choice between two prizes. The first provides $100,000 a day for d days; the second provides an amount of money that doubles in size each day for d days starting from a penny (so one penny the first day, two pennies the second, four pennies the next, etc.). a. Provide the formula for the amount of money after d days provided by each prize. b. Graph your results for values of d ranging from 0 to 31 days. c. Using your graph, advise the hero on which prize he should choose depending on the number of days d involved in the queen’s offer. 17.2 Imagine that you are a subject in one of Maurice Allais lab experiments involving the same four gambles as in the chapter. Gamble A provides a 89% chance of winning $1,000, a 10% chance of winning $5,000, and a 1% chance of winning nothing. Gamble B provides a 100% chance of winning $1,000. Gamble C provides an 11% chance of winning $1,000 and an 89% chance of winning nothing. Finally, gamble D provides a 10% chance of winning $5,000 and a 90% chance of winning nothing. Your utility function p over money is UðxÞ ¼ x. a. Compute your expected utility from each of the four gambles. b. In the first scenario, you are given a choice between gambles A and B. Which would you choose given your utility function? c. In the second scenario, you are given a choice between gambles C and D. Which would you choose given your utility function? d. Compare your choices in the two scenarios, and compare them to the actual experimental results reported in the text. 17.3 Refer back to Chapter 5, in particular to the Prisoners’ Dilemma in Figure 5.1. Imagine that these payoffs are monetary payoffs, with negative numbers being money that is taken away from a player. a. Suppose that players only care about monetary payoffs, with $1 ¼ 1 util. Find the pure-strategy Nash equilibria. b. Suppose that players have a preference for fairness. Each player loses 1 util for each dollar difference (in absolute value) between their payoffs. Show how the Prisoners’ Dilemma payoffs would change by writing down a new normal form. Find the pure-strategy Nash equilibria. c. Suppose that players have different fairness preferences than in part b. Suppose that only the player who earns less money cares about fairness. That player loses 1 util for each dollar less he or she earns than the other player. Write down the normal form of the Prisoners’ Dilemma reflecting these new preferences. Find the pure-strategy Nash equilibria. 17.4 Refer back to Chapter 5, in particular to the Battle of the Sexes in Figure 5.5. Imagine that these payoffs are monetary payoffs. a. Suppose that players only care about monetary payoffs, with $1 ¼ 1 util. What are the purestrategy Nash equilibria? b. Suppose that players have extreme preferences for fairness. Each player loses 10 utils for each dollar difference (in absolute value) between their payoffs. Show how the payoffs in the Battle of the Sexes would change by writing down a new normal form. Find the pure-strategy Nash equilibria. c. Suppose that players have different fairness preferences than in part b. Now only the player who earns more money cares about fairness. This player feels guilty about earning more, losing 10 utils for each dollar advantage. Write down the normal form of the Battle of the Sexes reflecting these new preferences. Find the pure-strategy Nash equilibria. 17.5 Refer to the Ultimatum Game in Figure 17.8. Recall that the payoffs are monetary payoffs. a. Suppose that players only care about monetary payoffs, with $1 ¼ 1 util. Find the subgameperfect equilibrium. b. Suppose that players are imperfectly altruistic. They receive 1 util for each dollar they earn but ½ util for each dollar the other player earns. Write down the extensive form reflecting the new payoffs. Find the subgame-perfect equilibrium. c. Suppose that players are perfectly altruistic, receiving 1 util for each dollar in the sum of their earnings. Write down the extensive form reflecting the new payoffs. Find the subgameperfect equilibrium. d. Suppose that players are perfectly selfless, getting 1 util for each dollar the other player earns but no utility for their own earnings. Write down the extensive form reflecting the new CH APT ER 17 Behavioral Economics payoffs. Find the subgame-perfect equilibrium. Does player 1 end up choosing the outcome that player 2 prefers? 17.6 Julia visits her local grocery store to buy a jar of jam. She is overwhelmed to see the twenty-four varieties shown in Figure 17.3 there. a. Suppose she makes her decision by evaluating every pair-wise comparison among the twentyfour varieties. How many comparisons does she have to make, and how long will it take her if she requires 1 second for each comparison? b. Suppose she uses a different system for making her decision. First, she considers each of the separate categories separately and making the pair-wise comparisons just within the category to find the best. Then, she takes the best from each category and makes all the pair-wise comparisons among them. Has she reduced the number of comparisons and the time it takes her to decide to use this system? 17.7 Will and Becky are two college students who are planning on Sunday how much they will study on Monday for a test on Tuesday. Will weighs future utility the same as current utility. Becky is more impulsive. She puts weight 1 on current period utility but only weight w on utility earned in future periods where 0 < w < 1. Let s be the cost in terms of utility on Monday from studying. Let b be the benefit in terms of utility on Tuesday from studying and thus performing well on the test. a. Under what condition on s and b would Will plan to study for the test? What condition is required for him to carry through on his plan? b. Under what conditions on s and b would Becky plan to study for the test? What condition is required for her to carry through on her plan? 17.8 In period 1, Mr. Consistency and Mr. Hyperbola are each trying to come up with a plan for how much they will exercise in period 2. Exercise is less enjoyable than other leisure activities, leading to a loss of 100 in terms of period 2 utils. Exercise provides health benefits, realized in period 3, leading to a gain of 250 in terms of period 3 utils. They put the following weights on utilities each period: Mr. Consistency Mr. Hyperbola CURRENT PERIOD PERIOD AFTER CURRENT ONE 1 1 0.5 0.35 TWO PERIODS AFTER CURRENT ONE 0.25 0.175 According to this table, Mr. Consistency’s weight on future utility falls by half each period. Mr. Hyperbola’s weights are related to Mr. Consistency’s; the difference is that Mr. Hyperbola’s are reduced a further 30% for periods after the current one. a. Would Mr. Consistency plan to exercise in period 1? Would he follow through on this plan in period 2? b. Show that Mr. Hyperbola would not follow through on his exercise plan. c. Suppose Mr. Hyperbola could sign a contract in period 1 that forced him to give up an amount of money valued at p utils in period 2 if he does not stick with his exercise plan. How high would p have to be to help him commit to his plan? 17.9 Prospect Pete’s preferences are given by the following utility function. His wealth prior to taking a gamble serves as a reference point. He gains 1 util for each dollar of wealth in the reference point. A gain beyond this reference point, this is worth 1 util per dollar. A loss below this reference point subtracts off 2 utils per dollar. Faced with the choice between gambles, he will choose the one giving the highest expected utility. He has signed up to be a subject in an experiment. Before starting the experiment, his wealth is $10,000. a. In a first experiment, he is given a choice between two gambles. Gamble A offers an even chance of winning $250 or losing $100. Gamble B provides $30 with certainty. Which gamble would he choose? b. In a second experiment, he is given a $100 starting bonus. Then, he is given the choice between two different gambles. Gamble C offers an even chance of winning $150 or losing $200. Gamble D results in a loss of $70 with certainty. What choice would he make if he calculates his reference point including the $100 starting bonus? Would his choice change his reference point is his initial $10,000 wealth, meaning that he considers the $100 starting bonus as part of the amount he gets from the gambles? c. Are Pete’s choices in parts a and b the same as he would make if he only cared about the final wealth level he ends up with after the experiment? 17.10 Trans-fatty potato chips are competitively supplied. The supply curve is Qs ¼ P : 2 647 648 PART SEVEN In pu t M arke t Demand for these potato chips is QD ¼ 100  2P: a. Compute the equilibrium price, quantity, consumer surplus, producer surplus, and social welfare. b. Suppose that consumers make irrational decisions either because of cognitive or willpower limitations, leading them to buy too many bags of potato chips. Although their true demand if they made rational decisions is as given already, their perceived or ‘‘mistaken’’ demand is QD ¼ 200  2P: Compute the equilibrium price and quantity now. Demonstrate the deadweight loss triangle on a diagram of the market and compute the deadweight loss. c. What per-unit tax could the government impose to correct this deadweight loss problem? d. Suppose instead the government made a mistake and the second demand is actually the true demand stemming from rational decisions. What deadweight loss has the government introduced with the tax? Author Queries AQ1: ED: Please check this occurrence? AQ2: ED: Cross reference missing for this footnote. Please check. AQ3: ED: In manuscript the footnote number 14 has given as 13. Please check. AQ4: ED: In MSS 4 found twice please check?