Steve Reads

Behavioral economics has gotten a bum rap for a while now. Perhaps the bummest of them all was Richard Posner’s dig in the middle of Frontiers of Legal Theory :

Behavioral economics is defined by its subject rather than by its method and its subject is merely the set of phenomena that rational-choice models (or at least the simplest of them) do not explain. It would not be surprising if many of these phenomena turned out to be unrelated to each other, just as the set of things that are not edible by man include stones, toadstools, thunderclaps, and the Pythagorean theorem.

The essence of this objection is that behavioral economics, for all its charms, isn’t a coherent set of ideas at all and serves mainly destructive ends. If that was ever true (hint: it wasn’t), it can be safely ignored now that Richard Thaler and Cass Sunstein have published Nudge. Nudge‘s purpose is to use our understanding of Man As He Is to build better policies. Rather than assume a perfectly rational human who can parse long, complicated documents with his mighty, limitless brain, Man As He Is sometimes skims and can be deceived by cleverly worded contracts. Man As He Is is often aware of his own limitations: he’ll flush his cigarettes down the toilet to prevent his future self from doing what his present self knows to be harmful; he’ll promise to start exercising tomorrow; and he’ll curse himself for procrastinating. Perfectly Rational Man — whom Thaler and Sunstein call an “Econ,” to be contrasted with a “Human” — would never have these problems. Econs sit down with (notional) pencil and paper and calmly work out the costs and benefits of all available actions, then take the action that maximizes their present and future happiness subject to a discount rate (future happiness is worth less than the same quantity of present happiness). They don’t have an internal procrastinator at war with a rational planner, nor do they ever regret on Sunday morning what they did on Saturday night.

Nudge is for Humans, not Econs. Nudge realizes, for instance, that making 401(k)s opt-out rather than opt-in, and setting a reasonable default investment plan, will lead lots more people to save money for retirement. And now that they’ve been enrolled, very few people will opt out. This is what Thaler and Sunstein call “libertarian paternalism”: giving people a gentle push in the direction of their own best interests (the “paternalism” part), but never taking away choices (the “libertarian” part). People can quit at any time; it’s only the default that has changed.

Your 401(k)’s default investment plan is part of what Thaler and Sunstein call “choice architecture.” As a 401(k) administrator, I can guide your choices in any number of ways. I can choose opt-in or opt-out; if I choose opt-out, I have to choose a default plan, whereas if I choose opt-in, I have to decide how much prodding to give you. The point is that choice is inevitable. There’s no way to avoid structuring the options available to people, so the right thing to do is to pick the best default. Given this realization, most of Nudge will be entirely uncontroversial.

Thaler and Sunstein digest a mountain of psychological research and reassemble it into a convincing story about how to build policies that correct for human failings. Humans can be expected to make the right decision when faced with a routine, concrete problem — buying food at the grocery store, say — but all bets are off when we’re asked to evaluate a complicated, large-scale problem like the impact of our air-conditioner usage on global climate change. Thaler and Sunstein want to give the market itself a nudge here. They wouldn’t insist that we buy only low-power appliances. Instead, they want our appliances to give us simple, immediate feedback on our energy usage: thermometers that reveal moment-to-moment energy costs, say, and EPA fuel-economy infographics that use easy-to-understand metrics like “dollars per year.”

Econs may be able to consume any information thrown at them and correctly render a judgment from what they read; Humans have finite attention spans and would rather spend time with their families than pore over fuel-economy tables. If we want Humans to make the best choices, we have to structure their choice environment to make this possible. Nudge is Thaler and Sunstein’s brilliant contribution toward this goal.

P.S.: Here would also be the place to recommend Thaler’s absolute gem of a book, The Winner's Curse. If you’re not sure whether you have time for a full book, and would like to get a taste first, I can’t commend your attention strongly enough to “The Law Of One Price In Financial Markets.” It’s one in a series of essays from the Journal of Economic Perspectives entitled “Anomalies”.