Paternalism in a Behavioral World protecting us from ourselves? protecting our ability to choose for ourselves? Lisa Wang SS 200 Wednesday,18 Feb. 2004

Overview Regulation & Behavioral Economics: Regulation & Behavioral Economics: how can the two be intertwined? how can the two be intertwined? Asymmetric Paternalism Asymmetric Paternalism Policy Applications Policy Applications Future Avenues for Research Future Avenues for Research

Regulation 3 different forms of regulation Redistribution Redistribution Counteract externalities Counteract externalities Paternalistic – help on an individual basis, “protecting us from ourselves” Paternalistic – help on an individual basis, “protecting us from ourselves”

Sources of Poor Decision-Making Bounded rationality Bounded rationality (slow) learning (slow) learning Framing Framing Lack of self-control Lack of self-control

Behavioral Economics Full Rationality ↔ Bounded Rationality ? 1. Well-defined preferences & utility maximization 2. Preferences accurately reflect the true costs/benefits of available options 3. Behavior under uncertainty: people have well- formed beliefs about how uncertainty resolves itself & will Bayesian-update their beliefs when given new info

How does behavioral economics apply to law & public policy? Evolution of law to meet efficiency needs Evolution of law to meet efficiency needs Laws gravitate toward socially useful forms even when their logic remains poorly articulated or their underlying philosophy comes under attack. Laws gravitate toward socially useful forms even when their logic remains poorly articulated or their underlying philosophy comes under attack. Efficiency - a richer conception? Efficiency - a richer conception?

Behavioral Economics - a justification or foundation for paternalism? Behavioral Economics - a justification or foundation for paternalism? Existing policies - can be interpreted as asymmetrically paternalistic, even though not conceived as such. Existing policies - can be interpreted as asymmetrically paternalistic, even though not conceived as such. How does behavioral economics apply to law & public policy?

Paternalism in a Behavioral World Pure Paternalism ↕ Asymmetric Paternalism Asymmetric Paternalism (benign paternalism, “paternalism for conservatives”) “paternalism for conservatives”)

Asymmetric Paternalism Why the asymmetry? - large benefits for those who make errors (who make suboptimal choices) - little or no harm for those who are fully rational (who reliably make decisions in their best interest)

Asymmetric Paternalism What’s it good for? propose new regulations propose new regulations framework for evaluating efficiency and robustness of existing policies framework for evaluating efficiency and robustness of existing policies

Asymmetric Paternalism: a metric for policy analysis 2 types of consumers - Boundedly rational (proportion p) B = net benefits to boundedly rational agents - Fully rational (proportion 1-p) C = net costs to rational agents I = implementation costs ∆∏ = change in firm’s profits due to the new policy

( p * B) – [(1 – p) * C] – I + ∆∏ > 0 Large benefits for boundedly rational agents → large B Little or no harm for fully rational agents → small C At least some boundedly rational agents → p > 0 Asymmetric Paternalism: a metric for policy analysis (cont’d)

Law & Policy Applications Default Rules Default Rules Provision or re-framing of information Provision or re-framing of information Cooling-off periods Cooling-off periods Limiting consumer choices Limiting consumer choices

Default Rules Status Quo Bias loss aversion loss aversion omission/commission bias (e.g. regretting one’s action, not inaction) omission/commission bias (e.g. regretting one’s action, not inaction) procrastination procrastination Applications to Contract Design consider the likelihood of error & cost of inefficient contract outcomes

Default Rules (cont’d) Insurance Rights - NJ: default to limited right to sue - PA: default to full right to sue - Outcome: 20% of NJ drivers chose to acquire full right to sue 20% of NJ drivers chose to acquire full right to sue 75% of PA drivers retained their full right to sue 75% of PA drivers retained their full right to sue

Retirement Saving: 401(k) retirement plan Automatic enrollment Automatic enrollment → rise in enrollment rates → rise in enrollment rates Caveat: lower contribution rates & more conservative asset allocations → decreased wealth accumulation, which offsets the increased wealth accumulation due to increased enrollment rates Caveat: lower contribution rates & more conservative asset allocations → decreased wealth accumulation, which offsets the increased wealth accumulation due to increased enrollment rates Default Rules (cont’d)

LESSON from Retirement Savings Example... Need to pay careful attention to... Need to pay careful attention to - Choice of defaults - Set of options available menu of N options → 1/N of savings allocated per option - Requiring to choose (from amongst a menu of options) → a net increase in savings Default Rules (cont’d)

Framing & Information Disclosure State Lotteries State Lotteries - Overweighing small probabilities of large salient outcomes - Provide associated probabilities and payoffs → alleviate cognitive errors? “Rent-to-Own” “Rent-to-Own” - Underestimating true costs: final prices customers pay are 2-3 times higher than normal retail price

Consumer Protection Consumer Protection Federal Truth in Lending Act * enable consumer to compare credit terms * enable consumer to compare credit terms * protect consumers against inaccurate credit billing/card practices * protect consumers against inaccurate credit billing/card practices Home mortgage disclosures Home mortgage disclosures Car leasing Car leasing Framing & Information Disclosure Asymmetric Paternalism in Practice

Investor Protection Investor Protection 401(k) Pension Right to Know Act of 2002 requiring employers to advise their employees to diversify investment of assets and minimize risk of holding securities of any one entity Withholding information Withholding information Anonymous review to avoid bias Framing & Information Disclosure Asymmetric Paternalism in Practice

Cooling-Off Heat-of-the-moment impulse Heat-of-the-moment impulse Sub-optimal response Sub-optimal response Hot-to-cold empathy gap / Projection bias Self-control problems → overweighing short-term benefits of indulging their current state of mind.

Consumer Protection Consumer Protection FTC-mandated cooling-off period for door-to- door sales. FTC-mandated cooling-off period for door-to- door sales. Family Law Family Law Settlement agreements Settlement agreements Cooling-Off Applications of Asymmetrical Paternalism

Limitations on Consumer Choice Deadlines: combating procrastination Deadlines: combating procrastination rolling deadlines vs. absolute deadlines deadline for Individual Retirement Account contributions

Framework for Policy Evaluation ↕ Paradigm for Policy Design Further Avenues for Research

Further Avenues for Research Applying Asymmetric Paternalism to Institutions Individuals ↔ Institutions Private Private Governmental Governmental A partial safeguard against a bad (activist) gov’t? - highly motivated consumers (e.g. with strong preferences) can override bad policies - highly motivated consumers (e.g. with strong preferences) can override bad policies - consistent with freedom of choice - consistent with freedom of choice - protecting us from ourselves while protecting our ability to choose for ourselves - protecting us from ourselves while protecting our ability to choose for ourselves