If you want to get up to speed on what behavioral economics is all about, two prominent speeches recently given at the annual meetings of the American Economic Association, held earlier this month in San Francisco, offer a useful starting point. The AEA Presidential Address was given by Richard Thaler on the subject of \”Behavioral Economics: Past, Present, and Future.\” The Richard T. Ely lecture was given by John Y. Campbell on the subject of \”Restoring Rational Choice: The Challenge of Consumer Financial Regulation.\” Campbell\’s lecture can be thought of as an application of behavioral economics to a specific policy area. The lectures will be published in print in the next few months. However, video of the roughly hour-long lectures accompanied by the slides, is available at the AEA website.
Thaler\’s lecture is, as the title suggests, is a broad overview of behavioral economics, and it should be quite accessible to a broad listenership. His basic argument is to point out simple economic models assume that economic agents (people and firms) seek to act in an optimal way. I would add that just to be clear, this approach to economic modelling is not the same as as arguing that people always have full and complete information, or that people have perfect abilities to perceive and calculate in all situations. It\’s not all that hard to do standard economic modelling with agents who lack full information or who can\’t do high-powered calculations very well, and as a result they will sometimes make mistakes. One way of restating the basic assumption of standard economics is that people will try to optimize, in the sense that at least they won\’t make the same mistakes over and over again.
Behavioral economics suggests that people often do make certain mistakes over and over again. People are often overconfident, and believe that they are well-above average in many categories. People have self-control problems when it comes to saving, exercising, diet, working hard. They are more averse to losses than they are enthusiastic about gains. They often stick with default choices, rather than considering alternatives. People often care about fairness, especially in social settings. They may be motivated in some settings, but not others. The idea of not making the same mistake over and over again probably works well when it comes to certain market with frequent and low-stakes interactions: int he market for restaurant meals, for example, if you hate the meal, don\’t go back. But lots of life decisions get made only once or a limited number of times, like choice of college major, career, who you marry, buying a house, or how much you save for retirement. Some of these choices are easier to alter than others! No one gets to rewind life, over and over again, so that you can learn from your mistakes and avoid them the second or third or 15th time around.
Thaler gives lots of example of how the kinds of people with these very real psychological biases will act in ways that, from the viewpoint of a standard economic model, will act \”irrationally.\” As a result, they will be situations where people make choices that they might later regret, ranging from small choices like paying for an extended warranty that never gets used up to large choice like those leading to bubbles and crashes in housing or stock markets. One of the most prominent examples in this literature is that if an employer puts workers into a retirement saving plan by default, they tend to stay in the plan, and if an employer doesn\’t put workers into a retirement saving plan by default, they tend to stay out of the plan. Thus, whether a given person ends up with retirement savings is often not a matter of personal choice, but a matter of what default was chosen by their employer. There are a very wide array of applications of these choices in many context: tax evasion, health insurance, Food Stamps, and many others. Thaler\’s lecture is a very nice broad overview.
John Campbell offers an application of these ideas in the area of household finance. His lecture is quite accessible, if not quite as accessible as Thaler\’s (that is, Campbell has a very small number of equations and reports a small number of statistical results). Campbell points out that people seem to systematically make what surely look like mistakes in their household decision-making. For example, some employers offer an \”employer match\” in retirement accounts–that is, if you put some amount like 5% of your income in a retirement account, the employer will also put in 5%. It\’s free money! But lots people don\’t take it. As another example, many people don\’t refinance their home mortgage when interest rates fall. Or many people put their retirement savings in a low-return financial instrument (like bonds) instead of a higher-return instrument (like stocks). Or many people take on lots of short-term debt at high interest rates, including with credit card debt, overdrawing their bank account and paying fees, or through payday loans. People are often financially illiterate, in the sense that they don\’t know the difference between a nominal and a real rate of interest, or how interest compounds over time, and similar problems.
Thus, Campbell argues that there is a case for financial regulation in certain settings that goes beyond the standard rules requiring disclosure of information, and moves toward setting rules. The tradeoff here is that setting specific rules can protect people from their own behavioral biases and ignorance. On the other side, rules may impose costs on those who are not so susceptible to such biases. As one example, consider the market for credit cards. The credit card companies offer what sounds like a very attractive deal: cash-back refunds, frequent flyer miles, and the like. Indeed, if you follow the rules and make all your payments in full and on time, and take advantage of the benefits, a credit card more than pays for itself. But if you fall behind in your payments, and start paying interest and fees, credit card borrowing can be very costly. If a new rule places sharp limits on credit card interest rates and fees, it will in some ways benefit those who could have become trapped in credit card debt (although they will also find it harder to get a credit card). But it also seems likely that if the credit card companies make less money from late fees and interest, they will also charge higher annual fees and offer less attractive options like cash-back and airline flights.
The case for rules that block certain fees or charges shouldn\’t be made casually, and the reason for the existence of economists in the universe is to warn about tradeoffs. But Campbell makes a strong case that in several contexts–getting people to invest long-term retirement accounts in stock, limiting the fees and charges from short-term borrowing through credit cards and payday loans, and reverse mortgages for the elderly–such rules are worth serious consideration.