Misbehavioral Economics?

Exchange of ideas
By Brian Mannix, Research Professor
June 17, 2015

“You must be the best judge of your own happiness.”  — Jane Austen, Emma

The Journal of Policy Analysis and Management has published a Point-Counterpoint exchange on the question of using “internalities” (aka “private benefits”) to justify government regulation of energy efficiency in appliances.  

The exchange includes four articles:

Allcott and Sunstein argue that consumers consistently err in making decisions to advance their own welfare, and that government agencies can make us better off by systematically distorting incentives in order to fool us into making better decisions, despite our flawed internal compass.  They illustrate this notion by building a model that discards the traditional inference that consumers’ decisions reveal their preferences; but, in its place, they adopt a set of assumptions that strain credulity.  “Imagine that all consumers have homogenous bias...While consumer bias is not a traditional market failure, the source of inefficiency is clear:  consumers...do not take the action even though their true utility exceeds the cost...The role of government in this model is also clear: if the policymaker subsidizes the action...,the social optimum is achieved...Notice here the direct analogy between internalities and externalities...It is thus useful to think of internalities as “externalities that individuals impose on themselves.”

Mannix and Dudley point out that the argument over “internalities” actually goes back at least to the administration of Jimmy Carter, when appliance efficiency standards were first proposed.  President Carter’s Regulatory Analysis Review Group (RARG) found the DOE’s explanation of consumer short sightedness unpersuasive.

While consumers still might be ‘myopic’ in considering future energy savings, the case is not nearly so clear-cut as it once might have seemed.” ...In the course of our review of DOE’s analysis, we have identified several assumptions and methodologies that appear unrealistic, unduly pessimistic about the workings of the market or of labelling, unduly optimistic about the effect of mandatory standards, or simply undocumented or unclear...The net benefits predicted for the proposed standards appear to derive largely from assumptions in the base case of extremely irrational behavior on the part of consumers...We suggest that this analysis be redone with more realistic and cautious assumptions and with lower standards.  (RARG, 1980)

Thirty five years later, advocates continue to advance unrealistic arguments about the superiority of government regulation over markets, even in the absence of any market failure.  Note that, before the government intervenes, there is no market failure in the Allcott and Sunstein model—only the presumed internal failure of consumer decisionmaking.  By using subsidies to distort prices away from true marginal cost, the government is giving false information to consumers, and creating a market failure where none existed. The magic in the model is that the government-manufactured market failure exactly offsets the presumed internal consumer failure, leading to a new equilibrium where resources are allocated optimally!  Of course, such a system would inevitably make unbiased, rational consumers worse off. The model only works because it assumes there are no rational consumers, somehow giving the government a monopoly on rationality.

We are not naïve. We recognize that even in a well-functioning democracy, there will be countless government policies adopted that could never pass a benefit-cost test. Sometimes there may be good overriding reasons for adopting them, but sometimes they are simply policy mistakes.  In either case, we ask that our economic analyses be transparent, honest, and objective about the effect on human welfare.  In the Kaldor–Hicks calculus, neither the government, nor corporations, nor any other artificial person gets a vote; only real humans experience welfare changes.  Neither does the government get to put its thumb on the scale.  Any truthful analysis of benefits and costs will tell us what consumers think, not what the regulator thinks consumers should think.  We do not allow the government to change the results of elections because of some theory of irrational and biased voters; neither should we allow it to distort consumers’ revealed preferences in an economic analysis.

Conventional benefit-cost analysis can be used to optimize policies that correct market failures, thereby improving the welfare of rational and autonomous consumers.  Paternalistic benefit-cost analysis, as espoused by Allcott and Sunstein, can be used to justify regulations that instead create market failures, thereby—if you believe the heroic assumptions—improving the welfare of irrational consumers. By systematically distorting prices and giving consumers inaccurate information, the rational, omniscient, benevolent regulator can correct our internalities and steer the economy to a more optimal set of decisions, even if we mere mortals are unable to see it.  Which set of assumptions sounds more realistic? Never mind that; which world would you prefer to live in?

“Better be without sense than misapply it as you do.”  — Jane Austen, Emma