Congdon William - Policy and choice: public finance throught the lens of behavioral economics

Acknowledgments

W e are grateful to the Smith Richardson Foundation, whose financial support made this book possible. We also are grateful to a host of individuals who read and commented on various drafts of this work, in whole or in part. We thank all of the people at ideas42, and the Brookings Institution whose ideas indirectly and directly contributed to the content here. We especially thank Hunt Allcott, Katherine Baicker, Rebecca Blank, John Friedman, Alex Gelber, Lisa Gennetian, Janet Holtzblatt, Lawrence Katz, Frank Sammaratino, Benjamin Schoefer, Josh Schwartzstein, Dmitry Taubinsky, and Bruce Vavrichek for insightful suggestions that improved this work.

We also thank seminar participants at the Congressional Budget Office, the University of Pennsylvania, and the Center on Children and Families at the Brookings Institution as well as participants and panelists at the First Annual Conference in Behavioral Economics, at a panel of the National Tax Association 2009 Spring Symposium, and at a session of the 2010 American Economic Association's annual meeting for their helpful feedback.

Special thanks go to two anonymous reviewers who provided extensive comments on an earlier draft of this manuscript. Their comments on every aspect of the text, ranging from specific citations to the overall organization of the material, were in every instance thoughtful and constructive, and the final version of this work owes their attention and diligence a great debt.

We extend our appreciation to everyone in the Economic Studies program at the Brookings Institution who had a hand in helping us complete this project. We single out for special thanks Karen Dynan, both for her general support of We single out for special thanks Karen Dynan, both for her general support of this work and for her role in overseeing its review, and Linda Gianessi, who kept everything on track and who patiently answered all of our questions throughout the process.

Great thanks are due to everyone at the Brookings Press, which had the job of making this book a reality. Managing editor Janet Walker capably shepherded the book through the publishing process. Eileen Hughes, our editor, worked tirelessly and skillfully to improve the clarity and precision of our writing. Marketing director Chris Kelaher did an expert job of developing and coordinating messaging about the book and its themes.

Finally, note that despite the multitude of people whose help we received in preparing this text, the views expressed here, and of course any remaining errors, are those of the authors alone. In particular, the views expressed in this volume should not be interpreted as those of the Congressional Budget Office.

Appendix

A

Preference, Choice, and Welfare

A s an additional step in integrating insights from psychology into public finance along the lines described in , does not employ the notation developed here.

There are two components to this model. The first includes the implications of behavioral tendencies for preference and choice. Imperfect optimization, bounded self-control, and nonstandard preferences mean that choice no longer reveals preference. The second includes the implications of choice behavior for how we think about welfare. The possibility that choice does not consistently reveal preference poses a challenge for evaluating welfare.

Preference and Choice

Perhaps the core insight of economics with respect to choice is that when the standard assumptions about individual choice hold, choice reveals preference. Findings from behavioral economics suggest that those assumptions often do not hold and that as a result choice may not reveal preference. We present a way to capture that aspect of choice and to compare how individuals make choices in the behavioral and in the standard model.

Setup

Let x = an action (such as consuming a good) that individuals choose to engage in or not.

Let b = the subjective valuation of x; in other words b = u(x).

Let c = the objective costs associated with x, denominated in the same units as b.

STANDARD MODEL

In the standard model, individuals choose x when the benefits outweigh the costs: b > c.

Different individuals value actions differently, so b is distributed f(b). For example, if x is consumption of donuts, high b individuals are those who love donuts. Furthermore, individuals optimize perfectly, have unbounded self-control, and hold standard preferences.

The key implication of this is that choice reveals preference: x iff b > c.

BEHAVIORAL MODEL

In a behavioral model, people are imperfect optimizers, have bounded self-control, and hold nonstandard preferences. We can represent those tendencies by saying that the choice of x now reflects the following decision criterion:

(b) > c,

where (.) is a transformation of the benefits, b, due to behavioral tendencies. So, for example, overconfidence about likely good outcomes might lead individuals to choose as though b were higher than its true value or procrastination might lead individuals to choose as though b were lower than its true value. When we make the simplifying assumption that c (the costs of x) are perceived without error, even by behavioral agents, then

(b) > b when behavioral tendencies lead individuals to overvalue x

(b) < b when behavioral tendencies lead individuals to undervalue x.

For example, when x is consumption of donuts, (b) might be greater than b due to failure of self-control or ignorance of the deleterious effects of donut consumption on health. This is a deliberately simple and flexible way to allow for behavioral tendencies; richer representations are clearly possible. The key feature of behavioral choice, which this model does capture, is that choice no longer necessarily reveals preference.

Choice of x occurs where (b) > c.

Because, in general, (b) b, it may be the case that individuals choose x when b < c and, conversely, that individuals fail to choose x when b > c. There is some true b that represents welfare, but in general it cannot be inferred from observable patterns of choice. Moreover, notice that markets under these conditions operate on (b), not b.

We can allow in this model that choice can be sensitive to features that do not matter in the standard model, such as framing or presentation effects. We call them nudges, following Thaler and Sunstein. In general, nudges affect the form of (-). But to reflect their importance, we can write that slightly less generally as (b, n), where n are nudges. Written that way, we get:

Choice of x occurs where (b, n) > c,

where different nudgesdefault rules, framing effects, appeals to social norms, and so oncan affect the choice of x, even when they do not alter the underlying costs and benefits of that choice.

Choice and Welfare

The failure of choice to reveal preference can create difficulties for public finance as well as for economic analysis more generally. What can we infer about welfare when choice does not reveal preference? That is, how do we infer b when people choose according to (b)? Or, if under different nudges we observe different revealed preferences (b, n), what do we take to be the true value of b? In considering social welfare, what b do we put in the social welfare function for people?

One way to model this indeterminacy that is useful for our purposes is to disaggregate the process of choice. Behavioral economists sometimes do so by referring to distinct conceptions of utility, where within any given individual we might think of there being what amount to multiple selves, each revealing different preferences through different processes. For example, we might think of time inconsistency as resulting from conflicts between a short-run self, the procrastinating self, whose preferences are revealed by choice, and long-run self, the patient self, whose preferences are revealed by what individuals intended to choose ex ante or what they wish that they had chosen ex post. And we can think about other choice inconsistencies in a similar fashion.