From “lather, rinse, repeat,” to how you invest for retirement, the way you
do most things now is the way you’ll continue to do them. That all-too-human
tendency to favor the familiar and resist change, called “status quo bias,” is
a central finding of behavioral economics — a discipline that fuses psychology
and economics. Behavioral economics has demonstrated that in money matters (as
in life), people are motivated by impulses that are
measurable and predictable — and often irrational. That won’t surprise anyone
who ever threw good money after bad, succumbed to a fad or ate the whole thing.
One of the founding fathers of behavioral economics, the late Amos Tversky of Stanford University, once quipped that the
scientific exploration of human behavior illuminated what was already obvious
to “advertisers and used car salesmen.”
And yet most economic models and the public
policies they inspire still assume that human beings behave like Mr. Spock of
“Star Trek.” According to the models, people are guided in their decision
making by a consistently rational and highly reliable sense of their own best
interest.
That notion is finally changing.
Behavioral economics first emerged some 30 years ago, most prominently with the research of Mr. Tversky and Daniel Kahneman of Princeton University. By the 1990s, the
field was being popularized. In 1990 and again in 1997, for example, Money magazine used behavioral economics to
create features and quizzes designed to explain why smart people make dumb
money moves. In 2002, Mr. Kahneman won the Nobel Prize in economics for his contributions to behavioral
economics. Increasingly, the field is attracting some of the brightest minds in
economics, involving the nation’s major universities and think tanks,
publications and conferences.
But it wasn’t until last year that behavioral economics first shaped public
policy in a big way, via the pension reform law of 2006.
That breakthrough — and its implications — were largely hidden in the
sausage-making process of passing the bill through Congress. But by applying
behavioral economics to Americans’ well-known lack of savings for retirement,
the new law serves as a primer on the discipline and how it may be used to
shape various public policies.
A key provision of the 2006 pension reform law allows an employer to
automatically enroll employees in the company’s 401(k) retirement plan, rather
than requiring them to sign up.
The idea for “auto-enrollment” came from research in behavioral economics
showing that status quo bias is prominent among the factors that keep
non-savers from participating fully in 401(k)s. The
tendency to continue doing what one has always done — such as spending one’s
paycheck rather than saving a portion of it — is often stronger than the
rational arguments in favor of joining the 401(k). Procrastination only
magnifies status quo bias.
Automatically enrolling all employees circumvents status quo bias — but not,
it’s important to note, by usurping choice. Employees are free to opt out if
they don’t want to participate. Once enrolled, however, status quo bias works
for — not against — the goal of bigger nest eggs, because saving a part of each
paycheck becomes the new norm, helping to ensure that workers stick with the
savings program.
The 2006 pension law also contains a mechanism to help employees overcome
“loss aversion” — a psychological phenomenon whereby people feel the pain of a
loss more acutely than the joy of a gain. Loss aversion is one of the reasons
that most employees are loath to ever increase the amount of money they
contribute to their 401(k) once it is set: A bolstered payroll deduction may be
perceived as a loss. So the new pension law provides for automatic escalation —
employers who automatically enroll their employees are also allowed to
regularly boost employees’ contribution levels, up to 6 percent of a worker’s
pay.
Loss aversion is related to another common foible, dubbed the “endowment
effect”: People “endow” their possessions, including their paychecks, with an
inordinately high value, simply because they possess them. When it comes to
savings behavior, the endowment effect predisposes people to value every dollar
currently in their pocket far more than the opportunity to save some of those
dollars for the future — a psychic recipe for coming up short in old age. By
automatically escalating 401(k) contributions, say, when an employee gets a
raise, loss aversion and the endowment effect are averted — and savings are
increased.
Still another behavior addressed by the new pension law is “decision
paralysis,” people’s tendency, when faced with too many choices, to decide not
to decide. If choosing is unavoidable and the stakes are high — as is the case
with 401(k) investing — many people will opt to play it safe by putting their
money in low-yielding, low-risk accounts. That’s the best way for them to ease
their troubled minds, but it probably won’t get them to a financially secure
retirement.
So the pension law instructed the Department of Labor to issue guidance to
employers on how to craft a standard investment option for employees who don’t
want to choose among various funds. Offering automatic investment in a
balanced, diversified fund ameliorates decision paralysis and, in the bargain,
advances the public policy goal of making a financially-secure retirement
attainable for workers.
II. Other Paths and Protections
Behavioral economics could enhance public policy in other areas as well. One
example is labor relations, where ample research has underscored the importance
of fairness in setting wages.
Another is the law. In situations involving monetary rewards, juries often
have no way of arriving at a correct figure. They may be hindered by their
abilities or by the novelty of a situation: How do you put a dollar amount on
pain and suffering? A common response to such unknowns is what behavioral
economists call “anchoring,” the inclination to seize on any given number as
meaningful. Thus, the mere mention of a plaintiff’s potential award — say, $10
million — has been shown to influence juries’ ultimate decisions.
Consumer protection is an area where psychological phenomena have been
largely overlooked, though that also may be changing. Behavioral economists
have been invited to participate in a conference this spring at the Federal
Trade Commission, which oversees consumer protection, on the implications of
their research for government policy.
Behavioral economics has made strides in showing how consumers respond when
faced with conditions that make it difficult to perceive the true price of a
product or service. Those conditions, detailed in a
recent paper by Jeffrey B. Liebman and Richard J. Zeckhauser, both of Harvard, include complexity
(roaming rates on cell phones, for example), a disconnect between consumption
and payment (as with water and electricity usage) or situations in which rules
change frequently (as in a policy arena like taxes).
In such cases, the human mind naturally resorts to shortcuts, like
averaging. Such use of elementary math, mental tricks and rules of thumb can be
useful in coping with demands on one’s time and abilities. But it often leaves
consumers with the sense of having made a more-or-less correct decision, when
in reality it often leads to computational mistakes and other errors that work
to their disadvantage.
Knowing this, might it be useful to require companies to show the full
estimated cost of owning a product, rather than the cost of buying it? Take the
Hewlett-Packard Deskjet 3747 Color Inkjet printer,
for example, which retails for $29.99, The Harvard economist, David Laibson, recently calculated that the printer’s four-year cost is $2,400,
when you include ink for about 20 black and white copies a day. Should that
information be prominently disclosed?
Behavioral economics could also be deployed to enhance public goals that we
already are striving to meet. We tax cigarettes, for example, in part because
we want to discourage consumption. High prices may deter young people from
picking up the habit or give smokers an added incentive to stop. Many
economists assume there is a limit to how high such taxes can go before they spawn
a black market or impoverish low-income smokers who cannot quit, concerns which
lead most tax authorities to limit tobacco taxes. But if there were no brakes
on the enforceable level of cigarette taxes, it would be possible to compute
a tax that would be adequate to snuff out most smoking.
Another antismoking tack explored by some behavioral economists picks up
where “sin taxes” leave off.
Unlike standard economic models, which assume that smokers make a rational
decision to smoke, behavioral economic models account for the irrational human
tendency, known as “hyperbolic discounting,” to give too little weight to the
future effects of current decisions. Hyperbolic discounting is akin to the
biases that lead people not to save for retirement, but in the case of smoking
it is intensified by an addictive short-term impulse (“I want a cigarette now”) that overwhelms most smokers’ desire to quit.
The distinction between the rational economic model and behavioral one is
crucial, because if smoking is rational, there’s little justification for
government intervention beyond preventing harm to others. Indeed, the need to
protect nonsmokers has been the rationale for most anti-smoking rules.
But what about the harm to the people who would like to quit, but can’t?
Clearly, most people know that they should quit (as they know they should save
for retirement, or pursue any number of other long-term goals). Behavioral
economics shows us that successful incentives must take into account biases
that defeat rational commitments.
Working from that insight, behavioral economists at Harvard and Yale have
recently proposed interventions designed to help smokers to self-regulate,
in effect allowing them to choose in advance the legal restrictions on their
cigarette purchases.
For example, the government could require special identification cards to
buy cigarettes. The cards would be free of charge, so as to impose minimal
inconvenience on people who want to smoke. But the need to apply, to carry the
card and to present it when buying cigarettes imposes delays and other
opportunities for would-be quitters to restrict their purchases. By choosing
not to apply for a card or not to carry one, a smoker would be making a
decision in the present that binds his or her options in the future. The aim is
to tame the self-defeating tendency to discount the distant effects of today’s
decisions and activities.
IV. The Politics of Behavioral
Economics
Arguments against taxes, social safety nets and government regulation are
generally premised on the notion that they distort the market by impeding the
pursuit of rational self-interest, the presumed driver of economic activity.
In 2001, for example, President Bush’s rationale for massive tax cuts was to
refund the budget surplus to the people, who, he said, would make better
decisions on spending the money than the government would. The reasoning has a
cocky appeal that meshes well with human beings’ intrinsic overconfidence, a
trait that has been amply demonstrated in behavioral economics. But was Mr.
Bush’s assertion true? Did it lead to the best policy? An alternative use of
the surplus would have been to pay down federal debt, thereby reducing the
government’s interest payments and freeing up money to pay the nation’s Social
Security obligations to baby boom retirees. Did the spending of tax refunds do
more good than strengthening Social Security would have?
Mr. Bush’s similar argument in favor of privatizing Social Security is that
individuals, investing on their own, could amass more money for retirement than
they would get from a government-run system. Again, this sounds appealing. But
is it realistic? Is it wise?
By deflating arguments that are based on the primacy of rational
self-interest, behavioral economics’ biggest impact may ultimately be on the
terms of economic debate.
“The presumption that individual choices should be free from interference is
usually based on the assumption that people do a good job of making choices, or
at least that they do a far better job than third parties could do,” wrote
Richard H. Thaler — another presumptive candidate for
the Nobel Prize — and Cass R. Sunstein, both of the
University of Chicago, in a recent essay. “As far as we can tell, there is little empirical
support for this claim."
The question for policy makers is not whether people can be counted on to
consistently make rational decisions that maximize their welfare —
demonstrably, they cannot. The question is whether corporations or government
or can do a better job.
And the challenge is to answer the question based on evidence, not
unexamined beliefs.
At times, market solutions to market problems have clearly been effective,
such as reducing acid rain by developing a system to trade pollution credits.
But if typical human biases undermine a policy goal, and those same biases
present a profit opportunity — selling cigarettes, for example — it’s silly to
pretend that the market will act as a corrective. “There’s no reason to think
that markets always drive people to do what’s good for them,” Mr. Thaler was quoted saying in a University of Chicago Magazine feature on behavioral
economics. “Markets also drive people to do what’s good for the people
selling.”
Questions of if and when the government should decide are also loaded.
Most any government intervention seems objectionable if you assume that
people usually make the best choices for themselves. That
anti-government sentiment is intensified if you also believe that markets are
impersonal, leading by some inexorable logic to optimal outcomes for
society-at-large.
Behavioral economists reject those assumptions. But it doesn’t automatically
follow that government solutions are inevitable or even desirable: Excessive
regulation of economic activity would lead to a nanny state.
In their articles and in a forthcoming book, titled “Nudge,” Mr. Thaler and Mr. Sunstein suggest a
middle ground. First, they point out the importance of acknowledging that in
many situations, some person or entity must make choices that affect others.
Think back, for example, to the pension reform law. Before automatic
enrollment, employers chose to require employees to enroll in a 401(k) plan.
Because of the employer’s choice, an employee who did not enroll would
contribute zero percent of salary to the plan. In other words, zero was the
default contribution. Mr. Thaler and Mr. Sunstein point out that in situations where it seems that
no one is making a controlling decision, it is usually because “the starting
point appears so natural and obvious,” it is taken as a given. Automatic
enrollment, however, is a different choice that establishes a different default
position. Is steering the employee in the direction of participating
objectionable? No, especially since the employee is free to opt out.
Which leads to their second point in the search for a
middle way between hands-off government and the nanny state. If no
coercion is involved, there is no justification for rejecting government
interventions out of hand.
Policies that do involve coercion — taxation, for one — obviously require
public support to be sustained. If the support dries up, the policy presumably
will, too.
But it is a mistake to oppose tax-supported programs like Social Security or
universal health care on the faulty assumption that everyone does better when
individuals take their best shots in the marketplace.
Critics of behavioral economics are quick to point out that government
officials are also human, subject to the same biases that trip up the rest of,
and thus would be no better at making decisions than anyone else. That’s an
oversimplification. Expertise, professionalism and experience work to mitigate
biases, as do debate, discussion, deliberation and oversight. In a functioning
democracy, we have a right to expect and demand those traits and processes in
government, in which case, we could rely on government decisions, at times,
more than our own.
This being a democracy, we could rely, but verify.