Ec345 Behavioural Economics: Theory and Applications

Week 10: Behavioural Welfare Economics

and Behavioural Public Policy
Alexander Dobson
University of Warwick, Department of Economics

December 2022

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Overview

Behavioural Welfare Economics

 Behavioural Economics and the Microeconomic Normative
 Choice-based and Outcome-based Welfare

Behavioural Public Policy

 A Pragmatic Approach (Chetty, 2015)
 Nudges – Shaping Choice Architecture
 Behavioural Public Policy: Broader Concerns
 Institutions, Public Agency and Well-being

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Behavioural Economics as Departure from Economics

Empirical evidence ‘refutes’ microeconomic assumptions?

 Mistakes, preference reversals
 Context-dependence, framing effects, loss aversion
 Time inconsistency, present bias

Microeconomic abstraction as benchmark

 Economics then explores qualifications to benchmark abstraction
 Behavioural economics as essential complement in this tradition

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Microeconomics, Qualified

Foundations: Standard model:

 (Rational) Consumer Theory
 Value interdependence: Game Theory, Public Economics
Behavioural economics (e.g. DellaVigna, 2009):
 Non-standard Preferences
• Individuals make choices (as-if) maximising a
utility function, using the information available,
and processing this information appropriately
• Preferences are assumed time-consistent,
affected only by own payoffs, and independent
of framing

 Non-standard Beliefs max ෍ 𝛿 𝑡 ෍ 𝑈(𝑥𝑡 |𝑠𝑡 ሻ𝑝(𝑠𝑡 ሻ 𝑠. 𝑡. 𝑥𝑡 ∈ 𝑋𝑡

𝑥𝑡
 Non-standard Decision Making and Well-being 𝑡 𝑠𝑡 ∈𝑆𝑡

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Neoclassical Welfare Assumptions (Bernheim and Rangel, 2007)

Common interpretation of neoclassical approach:

People have well-defined preference rankings, which can be discovered via observed choices (through the principle of
revealed preference) and which are taken as the basis for welfare evaluations.

Assumptions:
1. Coherent Preferences: Each individual has coherent, well-behaved preferences
2. Preference Domain: The domain of preference rankings is the set of lifetime state-contingent consumption paths
3. Fixed Lifetime Preferences: Each individual’s ranking of lifetime state-contingent consumption paths remains
constant across time and states of nature
4. No Mistakes: Individuals always select the most preferred alternative from the feasible set
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The Case for Mindless Economics (Gul and Pesendorfer, 2008)

What is the scope of economics – should economics restrict itself to choice data alone?

Gul and Pesendorfer present the case for such a restriction:

 Non-choice data is inadmissible as economics infers preference from observed choices
 Welfare and choice are identical – the reasons for choice are irrelevant
 Standard economics is without therapeutic ambition and does not try to improve the decision-maker

“Economics and psychology do not offer competing, all-purpose models of human nature. Nor do they offer all-
purpose tools. Rather, each discipline uses specialised abstractions that have proven useful for that discipline…
Economics and psychology differ in the questions they ask. Therefore, abstractions that are useful for one discipline
will typically not be very useful for the other.”
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The Case for Mindless Economics (Gul and Pesendorfer, 2008)

Economists are not advocates for any normative criteria, even when unambiguous
 Neoclassical economics is sufficiently flexible that the observed departures from the neoclassical model can be
explained by modifying the model without changing its nature
 Mistakes or biases can be accommodated by changing the set of feasible strategies
e.g. American tourists in the UK suffering injuries and fatalities because they look left when crossing the road – Gul
and Pesendorfer claim that the action ‘look right’ can be considered not in the feasible set(!), but if alerted with a sign
then their feasible set changes and they eliminate the apparent mistake

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The Case for Mindful Economics (Camerer, 2008)

The Foundations of Positive and Normative Economics (Caplin and Schotter, eds., 2008) provides a set of responses
to Gul and Pesendorfer (‘GP’)
For example, Camerer (2008):
 GP’s central arguments simply rely on subjectively defined boundaries of economics that are extremely
narrow, whilst behavioural economics illustrates the progress that can be made beyond these boundaries
 There is no debating an argument that is simply a definition, rather than an evidence-based case
 Simply extending neoclassical economics with auxiliary assumptions to explain observed departures from the
model may be considered “ad-hoc”
 American tourists are engaged in a “Stroop task”, where an automatic, highly practised response is incorrect –
and since people get better at a given Stroop task with experience, committing fewer mistakes, suggests not due
to changes in the feasible set
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The Restoration of Welfare Economics (Atkinson, 2011)

Claims welfare economics neglected due to economists:

i. Assuming away differences between people
ii. Assuming agreement in welfare criterion
iii. Assuming economics only concerned with identifying the possibility frontier

 Argues welfare economics should be restored to its previous prominence

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Individual-level Welfare Economics

(Rational) Consumer Theory

 As-if atomised value max: revealed preference
 Consumer surplus, compensating variation, equivalent variation

Game Theory, Public Economics

 Cooperation problems
 Externalities (‘maladjustments’)
 Public goods

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Behavioural Economics and Welfare

Non-Standard Preferences
 Present Bias
 Context-dependence, reference-dependence
 Interdependent preferences (status, social)

Non-Standard Beliefs
 Projection bias
 Probability misinference
 Overconfidence
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Behavioural Economics and Welfare

Non-Standard Decision Making and Wellbeing

 Fallibility, including systematic
 Heuristics and biases
 Direct wellbeing measurement

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Externalities, Choice Architecture and Incentives

Madrian (2014) 13
Behavioural Economics and Welfare: Summary

Contribution of Behavioural Economics:

 Structure of value
 Fallibility and different notions of value/utility
 Plausible systematic error
 Complementary welfare measures

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Overview

Behavioural Welfare Economics

 Behavioural Economics and the Microeconomic Normative
 Choice-based and Outcome-based Welfare

Behavioural Public Policy

 A Pragmatic Approach (Chetty, 2015)
 Nudges – Shaping Choice Architecture
 Behavioural Public Policy: Broader Concerns
 Institutions, Public Agency and Well-being

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Choice or Outcome-Based Welfare?

Welfare defined by choice distinct from welfare defined by quality of outcome

If relying on revealed preference approach to welfare, either assuming:

I. Preferences revealed in choice behaviour define welfare
II. Preferences revealed in choice behaviour are a sufficient approximation to ‘true’ outcome preferences or
wellbeing

Note:
▪ Considerable variation in terminology (see e.g. Sen, 1987, Harsanyi, 1997, Kahneman et al, 1997)
▪ Wellbeing may not be reducible to a single dimension (e.g. Heifetz and Minelli, 2016)
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Outcome-based Welfare: Rationality, Decision Utility and Experienced
Utility (Kahneman, 1994)

 Rationality as coherent preferences ≠ Rationality with respect to outcomes

 ‘Substantive/hedonic’ criterion for the rationality of a decision: does it maximise the expectation of
experienced utility?

Issues:
i. Correct prediction of future tastes – predicted utility
ii. Disparities between memory and actual experience

(but: outcome quality strictly defined by hedonic experience quality?)

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Wellbeing and Outcome Quality Measurement

Outcome-based welfare?
 Evaluate policy via direct measures of outcome value (e.g. subjective wellbeing, health outcomes etc.)
 Subjective wellbeing measures only one argument in the (true) utility function (Benjamin et al, 2012)

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Choice-based Behavioural Welfare Economics

Paternalistic implications of outcome-based welfare problematic?

 One option: extend standard choice-theoretic welfare analysis to incorporate frames or ‘ancillary conditions’
(Bernheim and Rangel 2007, 2009)
 Welfare criterion respects revealed preferences if unaffected by changes in ancillary conditions
 For critical discussion, see Infante et al (2016) and response, Hausman (2016)
 Alternative: simultaneously-held conflicting preference relations (Green and Hojman, 2007)

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Mechanisms of Systematic Fallibility

One mechanism for systematic fallibility in behavioural decisions: failure to take into account feedback from
actions to preference parameters (Dalton and Ghosal, 2012)
 Standard decision problem: max 𝑢(𝑎, 𝑠(𝑎ሻሻ
 Behavioural decision problem: max 𝑢(𝑎, 𝑠ҧ ሻ

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Overview

Behavioural Welfare Economics

 Behavioural Economics and the Microeconomic Normative
 Choice-based and Outcome-based Welfare

Behavioural Public Policy

 A Pragmatic Approach (Chetty, 2015)
 Nudges – Shaping Choice Architecture
 Behavioural Public Policy: Broader Concerns
 Institutions, Public Agency and Well-being

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Behavioural Economics and Public Policy (Chetty, 2015)

Pragmatic, policy-oriented approach: starting from policy question (e.g. how to increase savings rates), incorporate
behavioural factors (only) to the extent that they improve empirical predictions and policy decisions
 Claims follows in the methodology of positive economics advocated by Friedman (1953)

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Formalised Planners Objective (Chetty, 2015)

Formalised implications for public policy via simple representative-agent model where the planner’s objective is
to choose a set of tax rates t and nudges n that maximise the agent’s experienced utility subject to a revenue
requirement and a standard incentive-compatibility condition:

▪ c as the vector of choices made by the agent, p the pre-tax price vector, Z as the individual’s wealth
▪ u(c) as experienced utility or actual wellbeing, and v(c) as decision utility
▪ n as Nudges, those ancillary conditions that can be manipulated by policymakers (where d cannot) 23
Neoclassical Economics as Special Case (Chetty, 2015)

Neoclassical economics solves a special case of this general optimal policy problem, typically imposing the
additional constraints:
(4) The planner does not have any policy nudges n
(5) Decision utility is a smooth, increasing and concave function of consumption choices
(6) Experienced utility equals decision utility, u =v

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Behavioural Public Economics as relaxation of constraints (Chetty, 2015)

 Relaxing (4) yields new policy tools

- Nudges, shaping the choice context e.g. augmenting salience, or changing defaults
- Application: increasing retirement saving (see next section)

 Relaxing (5) yields better predictions about the effects of existing policies
- Application: effects of Earned Income Tax Credit on labour supply

 Relaxing (4) – (6) also yields new welfare implications

- Enhances normative understanding of the optimal design of policies
- Application: housing voucher subsidies
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Identifying experienced utilities (Chetty, 2015)

Optimal policy depends on experienced utilities, but economists reluctant to follow recommendations as concerned
about paternalism. Chetty offers three non-paternalistic methods of identifying experienced utilities:
1. Directly measuring experienced utility based on self-reported happiness
2. Using revealed preference in an environment where agents are known to make choices that maximise their
experienced utilities
3. Building a structural model of the difference between decision and experienced utilities

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Overview

Behavioural Welfare Economics

 Behavioural Economics and the Microeconomic Normative
 Choice-based and Outcome-based Welfare

Behavioural Public Policy

 A Pragmatic Approach (Chetty, 2015)
 Nudges – Shaping Choice Architecture
 Behavioural Public Policy: Broader Concerns
 Institutions, Public Agency and Well-being

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Nudges: Shaping the Choice Context

Most straightforward application of behavioural science – shaping the choice context

Libertarian Paternalism (Thaler and Sunstein 2003, 2008)

i. Libertarian: policies that maintain or increase freedom of choice
ii. Paternalism: influencing choices “in a way that will make choosers better off, as judged by themselves”

Potentially useful due to limited attention, information, cognitive abilities and self-control

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Nudges: Shaping the Choice Context

Thaler and Sunstein claim anti-paternalistic stances generally based on:

 A false assumption that people always make choices in their best interest
 Two misconceptions:
1. There are viable alternatives to paternalism
2. Paternalism always involves coercion

Goal: Reduce frequency of mistakes among those behaving suboptimally, without affecting those already optimising

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Behavioural Economics and Policy

Thaler and Sunstein (2008) Halpern (2015) Congdon, Kling and

Mullainathan (2011) 30
Aspects of Choice Architecture and Associated Nudges

1. Information
 Ease: college application assistance (Hoxby and Turner, 2014), choice of health plans (Bhargava et al, 2014)
 Salience, social framing: tax collection, fine payment (Halpern, 2015), energy bills (Allcott, 2011)
 Loss framing: teacher incentives (Fryer et al, 2012)
2. Broader choice context shaping
 Physical choice environment layout: cafeteria example (Thaler and Sunstein, 2008)
 Timing of choice: welfare payments (Barrera-Osorio et al, 2011), fertiliser use (Duflo et al, 2011)
3. Defaults
 Retirement saving (Chetty et al, 2014)

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Increasing Retirement Savings (Chetty et al, 2014)

Chetty et al (2014) contrast impact on retirement savings of:

 Neoclassical tools (t), tax subsidies for retirement saving
 New policy tools (n), defaults and automatic enrolment plans

First, neoclassical approach: in 1999, the Danish government reduced the tax deduction for contributions to capital
accounts for the top tax bracket from 59 to 45 cents per Danish Kroner

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Increasing Retirement Savings: Neoclassical Tools (Chetty et al, 2014)

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Increasing Retirement Savings: Neoclassical Tools (Chetty et al, 2014)

 Aggregate patterns appear to support the predictions of neoclassical life-cycle models of savings behaviour:
reducing the subsidy reduces contributions
 Individual-level responses suggest the entire effect is driven by the approx. 20% who are ‘active savers’, who
switch contributions from capital pension accounts to annuity pension accounts or other savings
 Approx. 80% are ‘passive savers’ who are unresponsive
 As a result, each $1 of tax expenditure on retirement savings subsidies increases retirement saving by
approximately $0.01 (in this context)

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Increasing Retirement Savings: Defaults (Chetty et al, 2014)

Large body of research suggests defaults can have a large impact on contributions to retirement accounts, despite
leaving incentives unchanged
e.g. Madrian and Shea (2001) where automatic enrolment increases participation from 20% to 80%
 Not clear if larger contributions at expense of less saving elsewhere, or less consumption
 Danish data in Chetty et al (2014) useful as contains information on saving in all accounts, exploiting variation in
employer contributions (analogous to changes in defaults)

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 Increasing Retirement Savings: Defaults (Chetty et al, 2014)

 Causal effect of employer pension contributions

on savings rates estimated by tracking individuals who
move to a firm that contributes at least 3%pts. more
 Individual contributions fall, but far less than the increase
in employer contributions, and other savings are
essentially unchanged (neoclassical life-cycle model
predicts individuals will fully offset)
 $1 increase in employer contributions increases net
savings by approximately $0.85

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UK Government: The Behavioural Insights Team

Initial MINDSPACE framework (Institute for Government, 2010)

Choice context issues:

 Messenger  Salience
i. Who citizen/recipient individual is engaging with
 Incentives  Priming ii. Full (not just economic) incentives
iii. Tendency rely on default
 Norms  Affect
iv. Sensitivity to salience, priming conditions,
 Defaults  Commitments affective associations, social norms and social
 Ego
commitments

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UK Government: The Behavioural Insights Team

Simplified EAST framework for day-to-day use:

 Easy
 Attract
 Social
 Timely

For accessible discussion and a plethora of examples, see Halpern (2015)

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Structuring the Choice Architecture (Johnson et al, 2012)

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Describing the Choices, and Implementation Issues (Johnson et al, 2012)

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Overview

Behavioural Welfare Economics

 Behavioural Economics and the Microeconomic Normative
 Choice-based and Outcome-based Welfare

Behavioural Public Policy

 A Pragmatic Approach (Chetty, 2015)
 Nudges – Shaping Choice Architecture
 Behavioural Public Policy: Broader Concerns
 Institutions, Public Agency and Well-being

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Microeconomic agents, Behavioural agents (Congdon et al, 2011)

Microeconomic Agents Behavioural Agents

 Unlimited cognitive capacities  Imperfect optimisation, simplifying heuristics

 No self control problems, time consistent  Bounded self-control, preference reversals

 Preferences over end states, and purely self-  Preferences over gains and losses, and other-
regarding regarding

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Behavioural Public Policy: Broader Concerns

Issues raised by behavioural economics go beyond merely shaping the choice context:
 Consumer and Financial Regulation
 Helping Consumers Know Themselves, Kamenica et al (2011)
 Applying Behavioural Economics at the Financial Conduct Authority, Erta et al (2013)
 Public Service Governance
 Behavioural Governance of Public Services, Bevan and Fasolo (2013)
 Institutions and Taxation
 Sin Taxes and Optimal Paternalism, O’Donoghue and Rabin (2003)
 Present bias and inadequate retirement saving: arguments for savings subsidies (O’Donoghue and Rabin, 2006), and credit
restrictions (Laibson et al, 2004)
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Behavioural Public Policy: Further Reading

Useful collections and texts on Behavioural Public Policy:

▪ Policy and Choice – Public Finance through the lens of Behavioural Economics, Congdon et al (2011)
▪ Behavioural Public Policy, Oliver, ed. (2013)
▪ The Behavioural Foundations of Public Policy, Shafir, ed. (2013)
▪ Psychological Science and Behavioural Economics in the Service of Public Policy, Meeting Summary, NIA (2013)
▪ Inside the Nudge Unit, Halpern (2015)

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Salience and Taxation (Chetty et al, 2009)

Central assumption in public economics: agents optimise fully with respect to tax policies
 Accumulating evidence suggests individuals are inattentive to some types of incentives (see DellaVigna, 2009)
 Chetty et al empirically explore the importance of tax salience (visibility of tax-inclusive price) via:
 Grocery store experiment
 Observational data relating alcohol taxes to consumption

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Salience and Taxation – Grocery Store Experiment Treatment

▪ In most retail stores in the US, if a

product is subject to sales tax this is
only added to the bill at the register
▪ To test if people underreact to the sales
tax when absent from the posted price,
for three weeks tags were added to
around 750 products in a supermarket
showing the tax inclusive price below
the original pretax price tags

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Grocery Store Experiment - Results

Quantity sold and total revenue in treated group of products fell by around 8 percent relative to controls
 Equivalent effect on demand as a 7.4 percent price increase

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Observational Evidence from Alcohol Consumption

Concern: reduction in demand due to “Hawthorne effect”, a short-run violation of norms

 Second empirical strategy: contrast effect of price changes with tax changes with observational data on beer
consumption by state in the US from 1970 - 2003
 Exploits state-level changes in excise tax (included in posted price) and sales tax (added at the register, less salient)
 Increases in the excise tax reduce beer consumption by an order of magnitude greater than the sales tax
 The difference in elasticities persists over time

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Salience: Important Factor in Response to Taxation?

Commodity taxes included in posted prices reduce demand significantly more than taxes that are not included in
posted prices
 Individuals seem well informed about commodity taxes when attention drawn to topic: when surveyed, the
median individual correctly reported the tax status of seven out of eight products
 This suggests salience may be an important determinant of behavioural responses to taxation
 If individuals make systematic optimisation errors even with relatively simple taxes, more complex policies (e.g.
income taxes, transfers) may result in behavioural responses very different to those predicted by standard
economic models

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Overview

Behavioural Welfare Economics

 Behavioural Economics and the Microeconomic Normative
 Choice-based and Outcome-based Welfare

Behavioural Public Policy

 A Pragmatic Approach (Chetty, 2015)
 Nudges – Shaping Choice Architecture
 Behavioural Public Policy: Broader Concerns
 Institutions, Public Agency and Well-being

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Subjective Well-being Evidence and Public Policy

Subjective well-being reports (in combination with other evidence) potentially inform our public policy response
to the structure of outcome-welfare:
1. Trade-offs between inflation and unemployment (see Week 7)
2. Positional externalities, adaptation and taxation
3. Public policy more broadly

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Happiness and Public Policy: A Challenge to the Profession (Layard, 2006)

Layard argues that the theory behind public economics needs radical reform

Claim - people in the West are no happier than 50 years ago, due to:
1. Happiness is negatively affected by the incomes of others (negative positional externality)
2. Happiness adapts rapidly to higher levels of income (potential negative ‘internality’)
3. Tastes are not given – happiness is culturally determined

Challenge to public economics is to incorporate the findings of modern psychology whilst retaining the rigour of
the cost-benefit framework

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A Corrective Tax for Social Comparisons (Layard, 2006)

1. Happiness is negatively affected by the incomes of others (negative positional externality)

❖ Policy: corrective tax, internalising the external cost

 Taxation generally can cause efficiency losses, but taxing negative externalities provides a means of raising revenue
that can potentially increase efficiency

Layard (2006) provides a simple benchmark abstraction: u = u ( y −  y , h)

where u is cardinal utility, y is real income, y is average income and h is hours of labour supply
 Effect of average income implies a negative externality
 Focus on efficiency aspect by assuming n identical people, with the same happiness function
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A Corrective Tax for Social Comparisons (Layard, 2006)

u = u ( y −  y , h)
The socially optimal level of individual work effort (h), incorporating the external disbenefit from the rise in
average income (adversely affecting all n people), is given by:

1
u1 − nu1 + u2 = 0 or u1 (1 −  ) + u2 = 0
n
u1 (1 − t ) + u2 = 0
Since under an income tax the individual will work until
the marginal tax t which results in the social optimum is t = 

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Taxation as an Institutional Solution to Positional Externalities

Income and consumption taxation of various forms are ubiquitous; whether initially driven by revenue-raising
dynamics, they may also serve an important role in constraining the excesses of economic competition
 To the extent that it is economic consumption that entails positional externalities, Frank (1997, 2005) suggests as
a solution a progressive consumption tax, with savings exempt
 Positional distortions require asymmetry in positionality across economic and non-economic goods, or income
and leisure
 Theory of optimal taxation technical, and sensitive to assumed structure of positional concerns
 Oswald (1983), Layard (1980), Aronsson and Johansson-Stenman (2008), Arrow and Dasgupta (2009)

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Further Policy Implications (Layard, 2006)

2. Happiness adapts rapidly to higher levels of income

❖ Policy: if imperfect foresight, negative ‘internality’, again suggesting possible corrective tax
❖ Loss aversion further suggests importance of stabilisation policy

3. Tastes are not given – happiness is culturally determined

❖ Policy: recognise costs of advertising and performance related pay; and values matter

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Understanding Happiness: Key Policy Implications (Sgroi et al, 2017)

Government measures of economic progress

should evolve to reflect the complexity of modern life
 Economic growth should not come at the expense
of other important aims that can enhance well-being
 Happiness measures have the potential to help
direct limited government resources toward the
most effective public policy interventions

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Understanding Happiness: Key Policy Implications (Sgroi et al, 2017)

Health and Social:

 Ensure mental health services affordable, widely available, easily accessible and less stigmatised
 Cultivate strong, positive networks, to challenge growing isolation and provide channels that spread well-being
 Funnel resources into activities that foster better health

Economic:
 Monetary and fiscal policies that foster economic stability are crucial for well-being, as high and stable
employment levels and the avoidance of runaway inflation are vitally important

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(One Senior Well-being Economist’s Judgment)

What might make countries happy:

 High social spending as a % of GDP

 Unemployment-insurance generosity
 Clear air (e.g. low SOx emissions)
 Low unemployment and inflation
 Low crime and corruption
 Openness to trade
 Genes
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General Conclusions

Behavioural welfare economics offers a useful extension to conventional welfare analysis

Behavioural public policy can be approached from a pragmatic, problem-oriented perspective

 Nudge-type interventions shape the choice context and encourage desired behaviours
 Well-being economics may have broad implications for optimal public policy

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