From “lather, rinse, repeat,” to how you invest for retirement, the way you do most things now is the way you’ll continue to do them. That all-too-human tendency to favor the familiar and resist change, called “status quo bias,” is a central finding of behavioral economics — a discipline that fuses psychology and economics. Behavioral economics has demonstrated that in money matters (as in life), people are motivated by impulses that are measurable and predictable — and often irrational. That won’t surprise anyone who ever threw good money after bad, succumbed to a fad or ate the whole thing. One of the founding fathers of behavioral economics, the late Amos Tversky of Stanford University, once quipped that the scientific exploration of human behavior illuminated what was already obvious to “advertisers and used car salesmen.”
And yet most economic models and the public policies they inspire still assume that human beings behave like Mr. Spock of “Star Trek.” According to the models, people are guided in their decision making by a consistently rational and highly reliable sense of their own best interest.
That notion is finally changing.
Behavioral economics first emerged some 30 years ago, most prominently with the research of Mr. Tversky and Daniel Kahneman of Princeton University. By the 1990s, the field was being popularized. In 1990 and again in 1997, for example, Money magazine used behavioral economics to create features and quizzes designed to explain why smart people make dumb money moves. In 2002, Mr. Kahneman won the Nobel Prize in economics for his contributions to behavioral economics. Increasingly, the field is attracting some of the brightest minds in economics, involving the nation’s major universities and think tanks, publications and conferences.
But it wasn’t until last year that behavioral economics first shaped public policy in a big way, via the pension reform law of 2006.
That breakthrough — and its implications — were largely hidden in the sausage-making process of passing the bill through Congress. But by applying behavioral economics to Americans’ well-known lack of savings for retirement, the new law serves as a primer on the discipline and how it may be used to shape various public policies.
I. Paving the Road to Riches
A key provision of the 2006 pension reform law allows an employer to automatically enroll employees in the company’s 401(k) retirement plan, rather than requiring them to sign up.
The idea for “auto-enrollment” came from research in behavioral economics showing that status quo bias is prominent among the factors that keep non-savers from participating fully in 401(k)s. The tendency to continue doing what one has always done — such as spending one’s paycheck rather than saving a portion of it — is often stronger than the rational arguments in favor of joining the 401(k). Procrastination only magnifies status quo bias.
Automatically enrolling all employees circumvents status quo bias — but not, it’s important to note, by usurping choice. Employees are free to opt out if they don’t want to participate. Once enrolled, however, status quo bias works for — not against — the goal of bigger nest eggs, because saving a part of each paycheck becomes the new norm, helping to ensure that workers stick with the savings program.
The 2006 pension law also contains a mechanism to help employees overcome “loss aversion” — a psychological phenomenon whereby people feel the pain of a loss more acutely than the joy of a gain. Loss aversion is one of the reasons that most employees are loath to ever increase the amount of money they contribute to their 401(k) once it is set: A bolstered payroll deduction may be perceived as a loss. So the new pension law provides for automatic escalation — employers who automatically enroll their employees are also allowed to regularly boost employees’ contribution levels, up to 6 percent of a worker’s pay.
Loss aversion is related to another common foible, dubbed the “endowment effect”: People “endow” their possessions, including their paychecks, with an inordinately high value, simply because they possess them. When it comes to savings behavior, the endowment effect predisposes people to value every dollar currently in their pocket far more than the opportunity to save some of those dollars for the future — a psychic recipe for coming up short in old age. By automatically escalating 401(k) contributions, say, when an employee gets a raise, loss aversion and the endowment effect are averted — and savings are increased.
Still another behavior addressed by the new pension law is “decision paralysis,” people’s tendency, when faced with too many choices, to decide not to decide. If choosing is unavoidable and the stakes are high — as is the case with 401(k) investing — many people will opt to play it safe by putting their money in low-yielding, low-risk accounts. That’s the best way for them to ease their troubled minds, but it probably won’t get them to a financially secure retirement.
So the pension law instructed the Department of Labor to issue guidance to employers on how to craft a standard investment option for employees who don’t want to choose among various funds. Offering automatic investment in a balanced, diversified fund ameliorates decision paralysis and, in the bargain, advances the public policy goal of making a financially-secure retirement attainable for workers.
II. Other Paths and Protections
Behavioral economics could enhance public policy in other areas as well. One example is labor relations, where ample research has underscored the importance of fairness in setting wages.
Another is the law. In situations involving monetary rewards, juries often have no way of arriving at a correct figure. They may be hindered by their abilities or by the novelty of a situation: How do you put a dollar amount on pain and suffering? A common response to such unknowns is what behavioral economists call “anchoring,” the inclination to seize on any given number as meaningful. Thus, the mere mention of a plaintiff’s potential award — say, $10 million — has been shown to influence juries’ ultimate decisions.
Consumer protection is an area where psychological phenomena have been largely overlooked, though that also may be changing. Behavioral economists have been invited to participate in a conference this spring at the Federal Trade Commission, which oversees consumer protection, on the implications of their research for government policy.
Behavioral economics has made strides in showing how consumers respond when faced with conditions that make it difficult to perceive the true price of a product or service. Those conditions, detailed in a recent paper by Jeffrey B. Liebman and Richard J. Zeckhauser, both of Harvard, include complexity (roaming rates on cell phones, for example), a disconnect between consumption and payment (as with water and electricity usage) or situations in which rules change frequently (as in a policy arena like taxes).
In such cases, the human mind naturally resorts to shortcuts, like averaging. Such use of elementary math, mental tricks and rules of thumb can be useful in coping with demands on one’s time and abilities. But it often leaves consumers with the sense of having made a more-or-less correct decision, when in reality it often leads to computational mistakes and other errors that work to their disadvantage.
Knowing this, might it be useful to require companies to show the full estimated cost of owning a product, rather than the cost of buying it? Take the Hewlett-Packard Deskjet 3747 Color Inkjet printer, for example, which retails for $29.99, The Harvard economist, David Laibson, recently calculated that the printer’s four-year cost is $2,400, when you include ink for about 20 black and white copies a day. Should that information be prominently disclosed?
III. Improving Public Policy
Behavioral economics could also be deployed to enhance public goals that we already are striving to meet. We tax cigarettes, for example, in part because we want to discourage consumption. High prices may deter young people from picking up the habit or give smokers an added incentive to stop. Many economists assume there is a limit to how high such taxes can go before they spawn a black market or impoverish low-income smokers who cannot quit, concerns which lead most tax authorities to limit tobacco taxes. But if there were no brakes on the enforceable level of cigarette taxes, it would be possible to compute a tax that would be adequate to snuff out most smoking.
Another antismoking tack explored by some behavioral economists picks up where “sin taxes” leave off.
Unlike standard economic models, which assume that smokers make a rational decision to smoke, behavioral economic models account for the irrational human tendency, known as “hyperbolic discounting,” to give too little weight to the future effects of current decisions. Hyperbolic discounting is akin to the biases that lead people not to save for retirement, but in the case of smoking it is intensified by an addictive short-term impulse (“I want a cigarette now”) that overwhelms most smokers’ desire to quit.
The distinction between the rational economic model and behavioral one is crucial, because if smoking is rational, there’s little justification for government intervention beyond preventing harm to others. Indeed, the need to protect nonsmokers has been the rationale for most anti-smoking rules.
But what about the harm to the people who would like to quit, but can’t? Clearly, most people know that they should quit (as they know they should save for retirement, or pursue any number of other long-term goals). Behavioral economics shows us that successful incentives must take into account biases that defeat rational commitments.
Working from that insight, behavioral economists at Harvard and Yale have recently proposed interventions designed to help smokers to self-regulate, in effect allowing them to choose in advance the legal restrictions on their cigarette purchases.
For example, the government could require special identification cards to buy cigarettes. The cards would be free of charge, so as to impose minimal inconvenience on people who want to smoke. But the need to apply, to carry the card and to present it when buying cigarettes imposes delays and other opportunities for would-be quitters to restrict their purchases. By choosing not to apply for a card or not to carry one, a smoker would be making a decision in the present that binds his or her options in the future. The aim is to tame the self-defeating tendency to discount the distant effects of today’s decisions and activities.
IV. The Politics of Behavioral Economics
Arguments against taxes, social safety nets and government regulation are generally premised on the notion that they distort the market by impeding the pursuit of rational self-interest, the presumed driver of economic activity.
In 2001, for example, President Bush’s rationale for massive tax cuts was to refund the budget surplus to the people, who, he said, would make better decisions on spending the money than the government would. The reasoning has a cocky appeal that meshes well with human beings’ intrinsic overconfidence, a trait that has been amply demonstrated in behavioral economics. But was Mr. Bush’s assertion true? Did it lead to the best policy? An alternative use of the surplus would have been to pay down federal debt, thereby reducing the government’s interest payments and freeing up money to pay the nation’s Social Security obligations to baby boom retirees. Did the spending of tax refunds do more good than strengthening Social Security would have?
Mr. Bush’s similar argument in favor of privatizing Social Security is that individuals, investing on their own, could amass more money for retirement than they would get from a government-run system. Again, this sounds appealing. But is it realistic? Is it wise?
By deflating arguments that are based on the primacy of rational self-interest, behavioral economics’ biggest impact may ultimately be on the terms of economic debate.
“The presumption that individual choices should be free from interference is usually based on the assumption that people do a good job of making choices, or at least that they do a far better job than third parties could do,” wrote Richard H. Thaler — another presumptive candidate for the Nobel Prize — and Cass R. Sunstein, both of the University of Chicago, in a recent essay. “As far as we can tell, there is little empirical support for this claim."
The question for policy makers is not whether people can be counted on to consistently make rational decisions that maximize their welfare — demonstrably, they cannot. The question is whether corporations or government or can do a better job.
And the challenge is to answer the question based on evidence, not unexamined beliefs.
At times, market solutions to market problems have clearly been effective, such as reducing acid rain by developing a system to trade pollution credits.
But if typical human biases undermine a policy goal, and those same biases present a profit opportunity — selling cigarettes, for example — it’s silly to pretend that the market will act as a corrective. “There’s no reason to think that markets always drive people to do what’s good for them,” Mr. Thaler was quoted saying in a University of Chicago Magazine feature on behavioral economics. “Markets also drive people to do what’s good for the people selling.”
Questions of if and when the government should decide are also loaded.
Most any government intervention seems objectionable if you assume that people usually make the best choices for themselves. That anti-government sentiment is intensified if you also believe that markets are impersonal, leading by some inexorable logic to optimal outcomes for society-at-large.
Behavioral economists reject those assumptions. But it doesn’t automatically follow that government solutions are inevitable or even desirable: Excessive regulation of economic activity would lead to a nanny state.
In their articles and in a forthcoming book, titled “Nudge,” Mr. Thaler and Mr. Sunstein suggest a middle ground. First, they point out the importance of acknowledging that in many situations, some person or entity must make choices that affect others.
Think back, for example, to the pension reform law. Before automatic enrollment, employers chose to require employees to enroll in a 401(k) plan. Because of the employer’s choice, an employee who did not enroll would contribute zero percent of salary to the plan. In other words, zero was the default contribution. Mr. Thaler and Mr. Sunstein point out that in situations where it seems that no one is making a controlling decision, it is usually because “the starting point appears so natural and obvious,” it is taken as a given. Automatic enrollment, however, is a different choice that establishes a different default position. Is steering the employee in the direction of participating objectionable? No, especially since the employee is free to opt out.
Which leads to their second point in the search for a middle way between hands-off government and the nanny state. If no coercion is involved, there is no justification for rejecting government interventions out of hand.
Policies that do involve coercion — taxation, for one — obviously require public support to be sustained. If the support dries up, the policy presumably will, too.
But it is a mistake to oppose tax-supported programs like Social Security or universal health care on the faulty assumption that everyone does better when individuals take their best shots in the marketplace.
Critics of behavioral economics are quick to point out that government officials are also human, subject to the same biases that trip up the rest of, and thus would be no better at making decisions than anyone else. That’s an oversimplification. Expertise, professionalism and experience work to mitigate biases, as do debate, discussion, deliberation and oversight. In a functioning democracy, we have a right to expect and demand those traits and processes in government, in which case, we could rely on government decisions, at times, more than our own.
This being a democracy, we could rely, but verify.
Lela Moore contributed research for this article.
