Individual-level Welfare Economics
Foundation=> benchmark model:
Rational Consumer Theory:
- As if atomised value maximisation
- Measure welfare through consumer surplus, compensating and equivalent variation, etc
Behavioural Economics and Welfare
Deviations from as-if assumptions of NeoClassical economics:
- Non-standard Preferences
- present bias => one of the main considerations, as the standard model assumes that we discount each time period with a constant discount factor but => hyperbolic discounting, present-bias, we discount the future heavily => evidence suggests a decreasing discount rate and and increasing discount factor.
- context-dependence, reference dependence as evidence of fallibility - Nick Chatex: context dependence means that we have no preference at all, no embedded structure of value. but not necessarily irrational, Male the mind is more complicated - Non-standard beliefs:
- projection bias
- overinderence that people are good at fund managing and neglect the probability of luck and the likelihood of small sample extremes
Contribution: - Structure of Value - reference dependent and relativity, positional concerns e.g. social references
- fallibility and different notions of value/utility – real value=/= experienced value
- plausible systematic error
- complementary welfare schemes
Kahneman 1994
Outcome-based Welfare: Rationality, decision Utility and Experienced Utility
Distinction between rationality as coherent preferences and rationality with respect to outcomes
Issues:
- correct prediction of future tastes - predicted utility
- disparities between memory and actual experience: peak-end bias: recollections distorted b the peak and how it ended
- if outcome based welfare, should evaluate policy via direct measures of outcome value e.g. SWB but as Benjamin et al 2012- SWB while it is the main predictor, other factors e.g. sense of purpose, control over own life, wellbeing of family
- who defines the outcome value? Paternalistic implications
=> Otherwise
- Choice-based welfare, Bernheim and Rangel 2007
Chetty 2015
Pragmatic policy oriented approach: Evaluate the theory based on predictions=> behavioural factors should be introduced when to improve predictions and policy directly
Formalises implications for public policy via a representative agent model
Chetty argues that behavioural economics can help public policy in three ways:
- Offer new policy tools e.g. framing incentives
- Yield better predictions by incorporating behavioural features e.g. inertia
- Generates new welfare implications - differences between welfare e.g. myopia generates welfare differences between a policy maker’s perspective (depends on the agent’s experienced utility (actual wellbeing) and decision utility (the objective the agent maximises when making the choice)
The model in public policy objective:
C: a vector of choices made by the agent - e.g. a set of different consumption goods but also choices such as labour supply
p: pre-tax price vector for the c goods
z: individual’s wealth
U(c): experience utility
V(c): decision utility - the objective he seeks to maximise when choosing c
As discussed in DellaVigna (2009): decision from experienced utility can differ because they have non-standard preferences e.g. social preferences, time-inconsistent preferences, reference-dependent preferences
or
because they are influenced by ancillary conditions - e.g. Bernheim and Rangel 2009 - following the Great Depression - loss aversion and negative outlook, even for those not affected greatly
The policy planner’s objective is to choose a set of taxes (t) and nudges (n) that maximise the individual’s experienced utility u(c) s.t. revenue (R):
(1) max u(c) s.t.
(2) t*c=R ==> maximise choices with taxes such that there is a fixed revenue
(3) c= arg max{v(c|n,d) ==> make choices that maximise decision utility such that the money is equal to the wealth
=> the restrictions typically imposed by neoclassical economics are that:
(4) the planner does not have any policy nudges,
(5) the agent’s decision utility is a smooth increasing and concave function and
(6) experienced utility is the same as choice utility
=> relaxing (4) yields new policy tools - nudges - make choices salient
=> relaxing (5) yields new predictions about policies - ancillary conditions to more accurately match behaviour
=> all yield new welfare implications enhance the understanding of policy design and esp. positional externalities and the neglect of positional bias
issue about paternalism: who gets to decide what maximises welfare, so Chetty offers three non-paternalistic methods of identifying
1) directly measuring experienced utility based on self reports
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
Thaler and Sustein (2003, 2008)
Libertarian Paternalism
i. Libertarian: preserving freedom - individuals are free to make their choices
ii. Paternalism: influencing choices in a way that will make choosers better off, if those individuals had full info, unbounded self-control and perfect cognitive abilities they would not need nudges => reason for paternalism - self- control probs e.g. O’Donoghue and Rabin 2003
Leans on soft paternalism: enhancing agency judged by themselves. If no coercion is involved, we think that some types of paternalism should be acceptable.
Example: Cafeteria and how you place the food
Cafeteria manager has three options - healthy choices first, randomly order the food, or put the unhealthy options where people are likely to get them – libertarian paternalism - rational to put healthy choices first.
Goal: reduce mistakes among those behaving sub-optimally without affecting those already optimising
Chetty et al (2014)
Behavioural approach of changing default recognising that people are fallible
Chetty et al. (2004) aim to contrast impact on retirement savings of:
- Neoclassical taxes and subsidies
- New policy tools e.g. nudges, defaults and automatic enrolment plans
Results:
1. neoclassical tools: reducing the subsidy reduces contributions - the change in incentive had a big effect but only by 20% of people that changed behaviour - the rest 80% are insensitive
2. defaults: large impact on contributions e.g. Madrian and Shea (2001)- automatic enrolment increases participation from 20% to 80% reaching people who were otherwise insensitive
=> Chetty uses Danish data on savings as useful and analogous to defaults
=> contributions jump by construction,
=> individual contributions fall but less than the increase in employer contributions
=> effects target active and passive savers and persist for a long time
Behavioural Public Policy: Broader concerns
- Consumer and Financial regulation
Kamenica et al (2011): Firms know more about the customer than the customer themselves (data) and should be available to consumers
-Public Service Governance
comparing behavioural ways to induce governments performance on education and health - Taxation
O’Donogue and Rabin 2006: present bias and inadequate retirement savings
Chetty et al 2009
Optimal taxation assumes people optimise to taxes as to prices
They empirically explore salience via
- Grocery store experiment
- Observational data relating alcohol taxes to consumption - posted tags showing the tax-inclusive price
Hypothesis:
Posting tax-inclusive prices has no effect on demand
Results:
- If fully optimising, putting tax on label should not matter, but salience matters
Why do consumers under react?
1. Lack of information - consumers are uninformed initially about the magnitude of taxes that are not included in posted prices
2. Salience matters - individuals know about taxes but do not pay enough attention
2 is more likely as individuals seem well-informed about taxes when surveyed
