- Humans can be primed by irrelevant information. Ariely et al. showed that a subject’s social security number could influence their valuation of a box of chocolates.,
- Behavioral economics for public policy is about…
- correcting mistakes in the predictions and valuations of standard economic models.
- designing novel policies.
- Main areas for the course: retirement, consumer finance, health, environmental policy, poverty alleviation.
- The standard model assumes exponential discounting in consumption decisions:
- \(c_t\) and \(y_t\) are consumption and income in period \(t\).
- \(T\) is when you die.
- \(u(c)\) is the utility of consumption.
- \(r\) is the discount rate.
- \(i\) is the interest rate.
- \(y_t - c_t\) is the savings or borrowings.
- People “smooth” consumption, saving and borrowing so that the marginal utility of consumption across periods is equal:
- People should be time consistent since utilities are relatively the same across time periods.
- Rational agents handle uncertainty by computing expected utility:
- People pay a premium to eliminate uncertainty. For retirement, people will buy an annuity, paying a lump sum to get a fixed payment until death.
Due to adverse selection, firms must continue to raise their premium as high-risk people opt out. Social Security resolves this and also redistributes income from the rich to the poor.
- Three behavioral issues undermine optimal saving and annuity purchase
- Present bias/temptation: There is a special preference for the immediate present over the future. As a result, people undermine their savings plans and procrastinate on saving, leading to undersaving.
- Myopia: People excessively discount the future. Perhaps they cannot envision the future, predict future anhedonia, or don’t feel strong self-continuity.
- Complexity: Hard decisions result in poor decisions guided by salient features of actions. Choice overload can result in no decision at all.
- Social Security forces people to contribute, while tax incentives encourage people and firms to save.
- Yet baby boomers are substantially undersaving. People want to increase their savings, but fail to follow through on their plans.
- Johnson and Goldstein found that opt-out organ donations significantly increases donation rates. According to Madrian and Shea, inertial plays a similarly powerful role in retirement savings. In an experiment with automatic enrollment, many more people enrolled in savings plans at the default rate.
- Defaults are much more cost effective. Chetty et al. measures the effect of incentives o be $0.01 of savings for each $1 spent on tax deductions. Meanwhile, each $1 increase in default increases retirement savings by $0.85. Active savers still rebalance their portfolios, so defaults assist those who are financial unsophisticated.
- People experience loss aversion. Once they own something, they value it more greatly (the endowment effect).
- The Save More Tomorrow program increases contributions with each pay raise until a maximum. It was more effective than a consultant and moved people into the recomended savings range. It relies on:
- Default bias - the predetermined contribution is a default.
- Present bias - Employees commit to the increases planned in advance.
- Loss aversion - Since it’s taken out of a raise, it doesn’t feel like a loss.
- People suffer from choice overload, where an abundance of choices induces people to choose nothing. In a classic study, Iyengar and Lepper find that people are much less likely to buy jam if they have to choose from 24 flavors than from 6 flavors. Similarly, too many essay topics reduces assignment completion rates, and too many choices of chocolate decreases satisfaction. In the context of savings, participation in 401(k) plans decreases as the number of choices increase.
- Mental accounting is the phenomenon of allocating income and expenditures to mental “accounts” and making financial decisions as if they were affected only by the constraints of the relevant account.
- Health and Soll found that people who recently paid for a basketball game were less likely to buy a ticket to a play than those who had just paid an equally expensive parking ticket.
- People rely on narrowly bracketed utility maximization to reduce the complexity of consumption decisions. O’Curry found that this extends to income sources too: frivolous sources of money were spent on frivolous expenditures. In Ishikawa and Ueda, the MPC from regular income was greater than the MPC from bonuses.
- Individuals with high self-continuity increased savings when reminded of their responsibility to their future selves. Hall and Fong used a similar intervention to increase exercise.
- Subprime mortgages involve:
- Cost deferral with a low to zero down payment and an increasing payment schedule, often including balloon payments.
- Complexity in rates and fees, often changing over time.
- Low requirements for borrowers pre Dodd-Frank.
- According to the standard model, people use exponential discounting and expected utility to make choices. They have correct predictions about future hosuing prices, inmterest rates, and income streams. they can find and porcess all relevnat information. As a result, borrowers maximize their welfare and competition should drive prices down.
- Problems with making loans:
- Present bias and mypopia
- Price discrimination is politicallly challenging, illogical.
- Many borrowers who took out subprime mortgages were not welfare-maximizing. They underestimated the cost of raising the interest rate on fixed-rate mortgages. New contractual designs such as hybrid loans (fixed and variable rates), interest-only loans, and option-payment adjustable-rate mortgages became more common.
- Subprime contracts were deceptive because of cost deferral and their level of complexity complexity.
- Traditional mortgages require a 20% down payment. From 2005-2007, most subprime borrowers put no money down. Subprime loans have increasing payment schedules, with higher interest rates after the first two years.
- Subprime mortgages often included multiple rates, an array of fees (credit check fees, certification fees, late fees, forelcosure fees, etc.) that can add up to 20% of the loan amount.
- The cost-deferral feature is rational if a) the borrower expects a higher income after the introductory period (which many did not) and b) the borrower expects to refinance and sell the house (often unrealistic).
- Subproblem mortgages are not clearly a tool for speculation, since many borrowers were not planning on selling or refinancing the home.
- Fluctuating and multiple interest rates are irrational since risks are passed on to investors. The rational choice model can’t explain non-optional fees.
- Behavioral economics explains contract design as a way to exploit the irrationality of borrowers.
- Myopic borrowers focus on the short-term. Optimistic borrowers underestimate future costs and overestimate income, refinance opportunities, and sale price.
- Irrational borrowers fail to aggregate price dimensions to compute the true cost.
- Borrowers were not reckless, they were imperfectly rational.
- Securitization obscured the risks of the mortgages, even for sophisticated investors.
- A proposal to disclose the APR could prevent problems arising from irrationality by combining multiple price dimensions into a single feature.
- The current regime fails because it fails to include all fees and assumes a full, thirty year loan.
Campbell et al. 2011
- Avoid politics (which leads to regulatory capture) and pet projects (which might not address real people’s needs).
- Interventions make sense in the context of : externalities, information failures, market power, public goods, cognitive biases, financial capabiltiies, and unfair outcomes
- Market research reveals at customers disapprove of financial products, especially if they are poorer. Respondents were most dissatisfied with credit cards, identity theft, and stored value cards.
- The highest priority targets involves high stakes, confusion, regret, folly, suckers, rip-offs, and opportunities.
- Consumers can be evaluated by homogeneity and financial sophistication. Public transit cards, for example, should be regulated more tightly than hedge funds.