jamesz

Where behavioural economics goes wrong

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We talked yesterday about the general issues that Wright and Ginsburg raise in their critique of behavioural economists. I don’t agree with their overall conclusions about the dangerous incoherency of the “behaviourists’ agenda”–if such a thing even exists–but they do make some excellent points about the limitations of the science as it stands.

The first stage of the behavioral economics research program is best described as developing a comprehensive theory of errors. The theory-building exercise thus far has focused largely upon the effort to catalog circumstances in which economic decision-makers appear systematically to depart from rational choice behavior. The second step required to make the theory of errors policy-relevant is to map the conditions under which specific errors are more or less likely to affect decisions and then to generate estimates of the social costs imposed by those errors. This step is particularly important when the incidence of a particular decisionmaking error is context specific, unevenly distributed throughout the population, and likely to interact systematically with other errors. The third step is to compare the costs of any proposed corrective intervention against the social benefits produced by reducing the rate of error. At present, however, research in behavioral economics does not appear to have moved much beyond the first step.

I think this is true, and similar to the point Eric made in his original comments. However, it is not a criticism of the science, but merely a statement about how young the discipline is. From the discussions so far we can add a couple more points related to policy development:

  • Policy conclusions need to be drawn from causal models, not correlations. That is the driving force behind the need for a coherent model supporting the idea of cognitive bias.
  • The behavioural approach needs to be applied to regulators, too. Public choice was a fairly late development in microeconomics so it’s not surprising that behavioural economists haven’t got there yet, but it is certainly a development that needs to occur so that we can think more deeply about policy failure.
jamesz

Layoffs have costs, too

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With the Ports of Auckland industrial dispute and the layoffs in the public sector, restructuring in the face of financial pressure seems very fashionable at the moment. Executives are quick to point to the cost savings of having fewer staff, or the potential productivity improvements. As the government says:

In a restricted funding environment we must find new ways to do more with less.

Of course, it is really only possible to do less with less, unless some staff are actually reducing what can be done. That seems unlikely, even though there may be some who are not providing value-for-money, as in any organisation. But there’s no point making a song and dance about obvious holes in what is more window dressing than substance. More interesting is to ask what the costs of these layoffs are. The short-term monetary costs to the organisation have been discussed by Danyl at Dim-Post:

…months of stop-work meetings, losing hundreds of millions of dollars in customers, sacking the entire work-force, paying millions more in redundancy and being placed on a global black-list is also going to compromise the efficiency and profits of the port, and its ability to return a dividend to the people of Auckland

The costs to those who have been laid off varies widely in monetary terms: some people will find jobs rapidly, while others languish on the unemployment benefit. But the real costs I want to discuss are the non-monetary costs to people’s wellbeing and self-worth. They’re the things you see on the front page of the newspaper, but aren’t often mentioned by economists talking about the macroeconomic impact. A recent NBER paper finds:

For those who are unemployed, the subjective well-being consequences can be divided into income and non-income effects, with the latter being five times larger than the former. This is similar to what has been found in many countries, as is our finding that the non-income effects are lower for individuals living in areas of high unemployment. …At the population level the spillover effects are twice as large as the direct effects, making the total well-being costs of unemployment fifteen times larger than those directly due to the lower incomes of the unemployed.

So the costs to society of the loss in self-worth from layoffs are huge. However, though these costs are large, it is worth asking ourselves how much account we want society to take of them. When thinking about non-monetary costs, it’s important to remember that a large part of the loss in welfare from unemployment is loss of social status. Now, loss of status isn’t something that affects everyone equally because people don’t start out with the same status prior to becoming The Unemployed. That manifests itself in ways that aren’t immediately obvious. For example, unemployment programmes that force a former accountant to work in fast food because they haven’t been able to find work elsewhere probably aren’t socially efficient: the loss in social status that the former accountant would suffer has large, long-term costs for their sense of self-worth. Since people are loss averse and work from the anchor of their current status, a reduction in their employment status is hugely costly to them. Because of that, it is hard to account for the social costs of unemployment without recognising that they are relative costs, and fall most heavily on those that were previously of high social status. That may not be something that an egalitarian society wants to take account of, given that the greatest absolute hardship is felt by those from poorer backgrounds who don’t have the same financial resources to fall on in difficult times.

jamesz

Competing with the stars

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Isn’t it wonderful to have role models around? Superstars in your firm that you can aspire to emulate! Well, maybe… Jennifer Brown recently published a paper suggesting that the presence of superstars in a competition actually decreases the effort that everyone else puts in to win. She uses data from Tiger Woods’ period of domination in professional golf to test the hypothesis that rivals will optimally put in less effort when playing Woods and finds:

  1. The presence of a superstar who uses pro clubs from clubgolf.com in a tournament reduced performance from other competitors, particularly the ones closest to Woods in skill.
  2. Reduced performance isn’t attributable to players closest to Woods adopting risky strategies in an attempt to beat him.
  3. The effect varies depending upon Woods recent success and how far ahead of his rivals he is perceived to be.

So, in a competition where only one person can win and there is somebody obviously head-and-shoulders above the rest, most others won’t put in much effort to win. It seems intuitively obvious but it’s always nice to have a bit of empirical evidence to back up your intuitions, especially when its a golfing example perfectly packaged for dinner-table trivia 😛

jamesz

Who needs a Nudge?

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I said last week that I’d come back to the critiques of bevhavioural economics but it’s obviously taken a while. Part of the reason is that I got wrapped up in this great essay by Joshua Wright and Douglas Ginsburg. It’s a blistering critique of the “behaviourist’s agenda” that you should really read if you’re interested in the subject. I don’t think there’s much attempt at balance in it but it raises some excellent points, as well as overplaying a number of weaker ones.

The essay can really be read as a libertarian response to Richard Thaler and Cass Sunstein’s work, summarised in their book, Nudge. For those new to the field, Thaler and Sunstein’s thesis is that choices can be framed in such a way that people will be more likely to do what is in their best interests, as they themselves judge it. The book has been hugely influential in defining the concept of libertarian paternalism, which is the idea that a ‘choice architect’ can improve welfare without reducing the freedom to choose. They do it by framing the choice in such a way that people’s cognitive biases will nudge them towards the welfare-improving option.

The easiest example of such choice architecture is through the setting of default options. For example, if there is a choice about which provider of government-supported retirement savings to use (ie. Kiwisaver providers in NZ), then the default option for people who do not actively choose a program should be one that is recommended by experts. Those who choose may still choose, but people who do not choose are allocated a plan that experts approve of. The idea of manipulating defaults is definitely something I want to get a whole post on, but let’s now turn to the fundamental critique of Wright and Ginsburg.

They pack in quite a few arguments but I’m going to pull out just a few that seem central.

How should one evaluate a regulatory intervention that would increase welfare but also diminish liberty? What are the mechanics of trading off welfare and liberty when the two are in tension?
…
If individuals are to realize their full potential …then they must be free to err in large ways as well as small. The fatal flaw of libertarian paternalism is to ignore the value of the freedom to err.
…
So long as behavioral law and economics continues to ignore the value to economic welfare and individual liberty of leaving individuals the freedom to choose and hence to err in making important decisions, “libertarian paternalism” will not only fail to fulfill its promise of increasing welfare while doing no harm to liberty; it will pose a significant risk of reducing both.

Essentially, they criticise behavioural economists’ focus on welfare to the exclusion of the “process of liberty”. It’s a difficult criticism to make because the idea of welfare is draw from a consequentialist, utilitarian framework, whereas the ‘process of liberty’ sound like more of a rights-based, deontological concept. To suggest that one limmits the other is a hard argument to make coherently when the utilitarian framework contains a complete moral philosophy of its own. It’s also interesting that they cite Mill’s support for their views since he firmly believed that utilitarianism was a moral philosophy that promotes liberty. To suggest that we could be following a utilitarian path and simultaneously reducing liberty seems like an argument that needed more time to make than they gave it in their essay. However, I’m no philosopher so I’m happy to be set straight here. We’ll discuss some of the more nitty-gritty aspects of the argument over the next week of so, because this debate is undoubtedly an important one for the progression of both the law and economics.

jamesz

Air NZ gentry reject free markets

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Suppose that a class-based system of privileges existed, in which you achieved high status through long participation in the rituals of the society. Those in the upper classes receive access to luxury goods not available to those of low status. Now suppose that the governing body of our society decided that luxury goods should really be available to everyone with the means to pay for them, rather than just the high status individuals. In fact, the luxury goods will now be sold to the highest bidder, who has the greatest desire for them (and means to pay). Well, that would seem pretty reasonable to most people, given that’s how most markets for goods work. We might worry about inequity because of ability to pay, but nobody would doubt that the luxuries will now go to people who really care about them. Economists would crow about the increase in efficiency in the system and the removal of deadweight losses.

Obviously, the people you’d expect to object would be those of high status, who’ve suddenly had their special privileges, that they’ve toiled to achieve, removed from them. The governors understand that they’d object so a scheme is devised by which people can get discounts on their luxury goods if they buy a lot of them, much as you’d get from many customer rewards programs where you can save up reward points and then spend them on goods from the store. The governors hope that grandfathering in the upper classes so that they have greater means than commoners will placate them. Unfortunately, they’re wrong: nobody likes getting their trinkets of status stripped from them.

Air New Zealand is being accused of driving away its most loyal customers with a recent overhaul of its Airpoints rewards system. …frequent flyers using their Airpoints to book flights on the national carrier will have to bid against each other to get seat upgrades. …The changes have sparked outrage among frequent flyers, with many threatening to shift their support to rival

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jamesz

A new perspective on sunk costs

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The fallacy of sunk costs occyrs when people take past expenditure into account when they make a decision, even though it cannot affect their future and cannot be changed. It is often regarded as a canonical example of a cognitive bias in humans because almost everybody does it. Of course, if it’s so suboptimal to take sunk costs into account then one has to wonder why humans have evolved to systematically make that error. Sandeep Baliga and Jeff Ely have a paper out where they suggest that it’s actually on optimal response to limited memory capacity:

We offer a theory of the sunk cost fallacy as an optimal response to limited memory. As new information arrives, a decision-maker may not remember all the reasons he began a project. The sunk cost gives additional information about future profits and informs subsequent decisions.

Essentially they say that, if you don’t remember all the reasons why you invested in the first place, then the level of past investment in a project tells you something about the conclusions you initially reached. You can then use that information to inform your decisions about whether to continue, without having to rethink everything from scratch.

Now I’m late to this because they also write the excellent Cheap Talk blog and discussed their working paper a year ago! So if you want to know the details of the ‘Concorde effect’ and ‘pro rata effect’ then head over and have a read.