jamesz

Behavioural economics and policy

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Stephen Gordon applies the Lucas critique to behavioural economics and nudges:

A key insight of behavioural economics is that people don’t always and everywhere re-optimise whenever their environments change. Instead, they will often – or even usually – make use of various rules of thumb and/or passively accept the default option. …This the idea behind ‘nudges’: you can alter people’s behaviour by making minor changes to the frames in which people operate…

But this only works if the change is subtle enough to not attact the full, direct attention of the decision-maker. If the change is big enough, people will haul out the full artillery of their rational selves in order to try figure out what optimal decision is. This means that behavioural economics is unlikely to be of much use in policy-making.

What he’s saying is a policy that takes advantage of people’s rules of thumb relies on them using the rules of thumb. If the policy is a big enough change in the circumstances they face then they might change their rule of thumb, which changes the effect of the policy. Unless you know how people form their heuristic, you can’t target it with policy.

For example, setting organ donation schemes to be opt-in by default may increase the level of donation because people don’t have a strong preference over whether they donate after death. If you applied the same reasoning to a decision that people care deeply about then it might have no effect because people will make the effort to choose their preferred option.

It’s an interesting point but I think Gordon goes too far by suggesting that it invalidates the targeting of behavioural heuristics. Read more

jamesz

Behavioural politics

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Niclas Berggren:

This study analyzes leading research in behavioral economics to see whether it contains advocacy of paternalism and whether it addresses the potential cognitive limitations and biases of the policymakers who are going to implement paternalist policies. The findings reveal that 20.7% of the studied articles in behavioral economics propose paternalist policy action and that 95.5% of these do not contain any analysis of the cognitive ability of policymakers. This suggests that behavioral political economy, in which the analytical tools of behavioral economics are applied to political decision-makers as well, would offer a useful extension of the research program.

This paper will be music to Eric’s ears!

HT: MR

Matt Nolan

Clarifying my question on habits

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I was glad that James discussed a bunch of the literature that uses habits and habit persistence yesterday.  I have run into the idea of habit persistence in consumption before while doing macroeconomic modeling, and it was good to see him bring it back to the observed phenomenon of reference dependence in individuals – as I stated, I wasn’t looking for ideas of how to model it directly, more an understanding of “what a habit is in the choice theoretic context”.

Reference dependence does explain a lot of the “why” I was looking for, as does “limited cognitive capacity”.  I think we still need to ask exactly how these processes work though.

And that is why reference dependence does not quite fully cover it off for me – undoubtedly because I am being fussy.  And this comes back to the logic behind why I decided to suggest “a choice of investment in a stock of habit” rather than just suggesting “that habits are described by a state variable that is a function of past action”.

What I really want to know is three-fold:

  1. What is the initial endowment of human habits,
  2. Can choices now relate to habits in the future in a purposeful way,
  3. The Lucas critique – but applied to habits.

Treating a habit like a preference (which is what much of the literature implicitly does) might be sufficient – but I do not believe so.  And that is because I think that many people “choose” to build habits and rules of thumb explicitly, given the underlying endowments and social situation around them.

This is a very important issue when we actually come to look at policy, for example:

  1. If habit formation adjusts to monetary policy settings that assume it, and we have put it in as a constant (eg rule of thumb consumer) then our settings will be inappropriate.
  2. In terms of time inconsistency, the development of habits can be seen as investment into an optimal “time consistent” path to improve outcomes.

My question isn’t “do habits exist” or “do we model habits”.  It is “are we currently modeling the development of habits in a way that is consistent with methodological individualism – that is consistent with individuals that make choice”.  Merely assuming an exogenous preference, doesn’t do this.

jamesz

How do habits help?

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We’ve posted over the past couple of days about habit persistence and you might be wondering why anyone would care. It turns out that habit persistence is extremely powerful in explaining some important macroeconomic dynamics:

When habits are formed at the level of individual goods, firms take into account the fact that the demand they will face in the future depends on their current sales. This is because higher consumption of a particular good in the current period makes consumers, all other things equal, more willing to buy that good in the future through the force of habit. Thus, when habits are deeply rooted, the optimal pricing problem of the firm becomes dynamic.

[This paper embeds] the deep-habit-formation assumption in an economy with imperfectly competitive product markets. This combination results in a model of endogenous, time-varying markups of prices over marginal cost [with] markups [that] behave counter-cyclically. In particular, expansions in output driven by demand shocks are accompanied by declines in markups. This implication …is in line with the existing empirical literature. In addition, …because of the strong counter-cyclical movements of markups, [habit persistence] is capable of explaining increases in wages and consumption in response to a positive demand shock as is observed in the data. This latter empirical regularity has proved difficult to explain with standard models of the transmission of demand shocks.

jamesz

Why do people form habits?

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Matt stormed back on to the blog yesterday with a post on the importance of habits in explaining human behaviour. Here I want to explore the way in which economists describe habits in a bit more depth. In particular, Matt asked why economists talk about habit persistence in such an ad hoc way. I don’t think it’s very ad hoc at all and I’ll try to explain why.

What are habits?

Having a habit means that you’re more likely to do something the more you’ve done it in the past. You’ve done it before, so that makes you more likely to do it now. The implication is that your current payoff from the activity depends upon how much you’ve done it in the past. The ‘how much you’ve done it in the past’ is what Matt refers to as ‘capital’, in the vein of Becker and Murphy’s seminal discussion of cigarettes.

How do economists describe habits?

Now the description in economic models is fairly obvious: your ‘utility’ depends not just on how much of something you get today, but also how much you got in the past. The easiest way to model that is to take the difference of today’s consumption and yesterday’s. That way, you want to consume more of something than you did yesterday, and consuming less than yesterday will make you less happy. Essentially, yesterday’s consumption can be thought of as the stock of ‘capital’ that Matt referred to. The more capital you’ve built up over time, the more you want to do the thing again today. Hence, with this simple mechanism, we get habit formation and persistence.

What I’ve just described is called ‘internal’ habit persistence because it depends on your personal consumption levels. However, it is easily generalised to societal habits by taking the stock of built up consumption to be average social consumption, or the consumption of one’s neighbours. Then we call it ‘external’ habit persistence.

Why do they do it that way?

So far so good, but the question Matt asked is why it’s modelled that way. As he pointed out, it’s not enough just to say it fits the observed behaviour: we also have to ask why. Now that we’ve got this far it’s actually fairly straightforward. Habit persistence is simply the dependence of your personal payoff on a reference level of consumption, as opposed to being dependent on the level of consumption.

Economists have studied reference dependence ever since the canonical work of Kahneman and Tversky on prospect theory back in 1979. They drew on the psychological evidence to show that people care not about the level of consumption but the change in consumption relative to some reference point. Now, there is a lot of discussion about what an appropriate reference point is. Depending on what the reference point is you can get very different behaviours, and there can hardly be a dozen different reference points (although some weighting across them may be plausible).

The main point for our discussion is that viewing habit persistence as the result of reference-dependent utility allows us to sheet it back to some empirical literature on psychology and behaviour.

Matt Nolan

Habit formation and the economic core

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I have repeatedly been informed that the “economic man” is a poor description of individuals, and given this economic models provide a poor description of the world we live in.  As I have said previously, I don’t agree with this conclusion – and we really need to ask what an economic model is, and why we are using it, to understand the scope of economics and the appropriateness of the assumptions.

In essence my view is that we use economic models to describe, and in some way explain, tendencies that exist (from induction) using assumptions about choice that satisfy two conditions:

  1. They are as weak and loosely binding as possible
  2. They are appealing in the sense that, when I ask myself about my actions I can deduce laws that guide them.  I could go a step further and say that we can set up “ideal experiments” in our minds, but I’ll leave that for now.

This is all well and good.  But then someone will say “what about habit formation“.  This is an important issue, people obviously develop habits and these habits bind and constrain behaviour.

In fact, I would go as far as to say that habits, and the formation of habits, provide the key to tying together a lot of different strands in experiments and behavioural economics – and that an understanding of habits and habit formation is an important part of improving economists way to describe the world and give advice.

So how do we “describe habits”?

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