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Public Choice

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29-11-2017

Can behavioral economists improve economic rationality?

Authors: Dwight R. Lee, J. R. Clark

Published in: Public Choice | Issue 1-2/2018

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Abstract

Behavioral economists recognize that we are all subject to the cognitive biases they have observed and studied in laboratory experiments. Yet the leading behavioral economists exhibit far more interest in applying those biases to market decisions than to political decision-, and see irrational decisions making as another example of market failure which justifies correction by some form of government action. We treat this as a justification for comparing the distortions of cognitive biases on market decisions with the distortions of those biases on political decisions. We also make a distinction between the rationality of individual decisions and the collective rationality of those decisions, and question Thaler’s argument that people fail to learn much from the mistakes they make in markets. We conclude that behavioral economists would do more to increase economic rationality by making the case for eliminating government policies that are clearly economically irrational and destructive. Eliminating such policies would not necessarily increase the individual rationality of political or market decisions, but it would increase the collective rationality of both.

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According to Buchanan (1979, p. 31) “[i]t is a[market] setting, an arena, in which we, as economists,… observe men attempting to accomplish their own purposes, whatever these may be. And it is about these attempts that our basic theory is exclusively concerned…”.

Richard Thaler, winner of the 2017 Nobel Memorial Prize in economics for his pioneering work in behavioral economics, published a regular feature in The Journal of Economic Perspectives titled “Anomalies” from 1987 to 2006.

See Schnellenbach and Schubert (2015) for a survey of the literature in this emerging field.

Kahneman (2011, p. 259) agrees when stating “optimistic risk taking of entrepreneurs surely contributes to the economic dynamism of capitalistic society, even if most risk takers end up disappointed.” Furthermore, he expresses concern that founders of small businesses that are most likely to end up badly will ask government for support.

See https://mises.org/blog/trump-budget-real-cuts-vs-media-version-cuts.

There are far more serious false claims than the definition of a budget cut. We still hear politicians claiming that the surpluses from Social Security payroll taxes exceeding the amount paid out are accumulating in a “trust fund” instead of being spent for current federal expenditures. Some even refer to a “lockbox” containing the funds. The surpluses are spent; the trust fund is simply an accounting arrangement in which surplus Social Security payroll taxes are credited even though they are spent. See Cogan (2017, Chapter 8).

The attention investors give to fraudulent corporate practices can be reduced by the belief that the Securities and Exchange Commission is doing a better job moderating those practices than it is. Nelson (1977) has made the same argument with respect to the confidence consumers have in the effectiveness of the truth-in-labeling laws enforced by the Federal Trade Commission. We thank William Shughart for alerting us to this problem.

Quoted in Ricks (2017, p. 242).

For a discussion of an experiment showing this, see Ariely (2008, pp. 127–33). See Kahneman, Knetsch and Thaler (2004) for a more technical discussion.

See Kahneman (2011, p. 349).

Ariely (2008, p. xx) also dismisses “market forces” with more sarcasm when he states “What if we make a mistake and do something irrational? Here too, traditional economics has an answer: ‘market forces’ will sweep down on us and swiftly set us back on the path of righteousness and rationality.” Note that Ariely also dismisses markets, in this case, market forces by putting the phrase in quotation marks.

In many cases the endowment effect can be explained as differences in consumer’s surplus. Indeed, WTP = WTA applies only to the marginal purchaser of a product. Most consumers receive a consumer’s surplus above the amount they pay for something. We agree with Adam Smith, however, that ownership can add to the value of a product—increase the owner’s consumer surplus.

Thaler (2015, p 165) discusses taxes, but to consider why “firms punish their tax-paying shareholders by paying dividends”; if tax-sheltered retirement saving plans “were increasing saving or just shifting money from taxable accounts to tax-free accounts” (p. 310); how to get the English to pay their taxes promptly (p. 335); and whether people or firms will use a tax cut to spend more on goods or hire more workers to produce goods. (pp. 350–351) Without belittling these questions, a far greater concern is the tremendous cost of the irrational economic decisions motivated by our excessively complicated and loophole-ridden tax system that has resulted from political decisions.

Relevant to this problem, see Tullock (1975), who argues that even though programs may provide temporary advantages to particular groups, those advantages are typically competed away leaving the initial beneficiaries no better off than before, even though the program’s economic inefficiencies remain. Yet, eliminating, or even scaling back the program imposes losses on those who invested to qualify for the program’s benefits. One interpretation of Tullock’s argument is that the more inefficient is the program, the more those who invested to qualify for its benefits lose if it is eliminated, and the harder they will fight to keep it.

Making this comparison is commonly discussed in terms of discounting the future. This creates interesting technical issues that some behavioral economists have discussed, such as the differences between exponential discounting, which applies the same discount rate through time, and hyperbolic discounting, which finds the discount rate varying through time. Behavioral economists are not adamant about which is more appropriate and the differences are not considered here.

Over 9 billion chickens are killed each year in the United States. See http://www.answers.com/Q/How_many_chickens_are_killed_per_year.

Singer (2016) argues against donating to the Make-A-Wish Foundation because the amount of money required to give one child in America a wonderful experience would save the lives of three unidentifiable children in tropical countries if donated to the Against Malaria Foundation for mosquito-resistant bed nets.

Drugs developed to treat rare diseases.

A 20% marginal excess burden is a conservative assumption. Browning (2008, p. 156) cites evidence that raising another dollar with the federal income tax costs society between $1.30 and $1.50, implying a marginal excess burden of between $0.30 and $0.50.

See Kahneman (2011, Chapters 1–3). Briefly, System 1 reaches conclusions on the basis of intuitive understandings that require little thought, while System 2, which requires serious concentration and careful thought, is brought into action only when the person making a decision has a lot at stake in reaching a rational conclusion.

See Kahneman (2011, p. 164) where he refers to the laziness of System 2. See McKenzie (2010, Chapter 8) who sees the cognitive biases the behavior economists see as irrational as evidence that the brain as optimally rational.

It should be noted that out-of-pocket costs also count as opportunity costs.

Interestingly, this example is in a chapter on “The Endowment Effect.” We see no reason why the endowment effect cannot apply to the consumption of an item, even though it’s value could be maintained indefinitely. For example, if someone with no interest in collecting wine, and who never paid more than $15 for a bottle, received an expensive bottle of wine from a special friend, he might choose not to sell it for $100 because it is was worth more to him to drink in celebration of a joyous occasion. Even if you don’t want to explain this as an endowment effect, it is not irrational.

Kahneman (2011, p. 346) mentions that corporate managers often lose their jobs for reluctance to terminate a losing investment. But we have seen no discussion in Kahneman, or any other behavioral economist, acknowledging that government programs that have wasted billions of dollars are seldom terminated and often expanded.

See Heukelom (2014, pp. 165–166) on the difference between Smith and behavioral economists on the importance of time in improving economic decisions.

Ariely, D. (2008). Predictably irrational: The hidden forces that shape our decisions. New York: Harper Collins.

Ashraf, N., Camerer, C. F., & Loewenstein, G. (2005). Adam Smith: Behavioral economist. Journal of Economic Perspectives, 19(3), 131–145.CrossRef

Bastiat, F. (2012). The law, and the state, and other political writings, 1843–1850. In Jacques de Guenin (Ed.), The collected works of Frederic Bastiat. Liberty Fund: Indianapolis.

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Title: Can behavioral economists improve economic rationality?
Authors: Dwight R. Lee
J. R. Clark
Publication date: 29-11-2017
Publisher: Springer US
Published in: Public Choice / Issue 1-2/2018
Print ISSN: 0048-5829
Electronic ISSN: 1573-7101
DOI: https://doi.org/10.1007/s11127-017-0487-z

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