Policy and Choice:

Public Finance Through the

Lens of Behavioral Economics

Congdon, W., J. ling and S. Mullainathan. (2011). Policy and

Choice: Public Finance Through the Lens of Behavioral Economics.
Washington, D.C.: Brookings Institution Press
 OUTLINE
Introduction
I.

Psychology and
II.

Economics
III. Behavioral Economics and
Public Finance

2
I.
Introduction
3
INTRODUCTION
× Traditional Public Finance provides a powerful
framework to tackle economic questions.
However, it relies on an overly simple model of
human behavior.
× Congdon et al. explored how psychological factors
reshape core public finance concepts such as
moral hazard, deadweight loss, and incidence.

4
× Example: TAXES
‐ Traditional public finance has a well-developed
framework for determining how to set taxes optimally:
models of incidence, models of efficiency
‐ Behavioral economics complicates this logic.
‐ Salient vs. Non-salient taxes
‐ Failure to respond to a non-salient tax → error
‐ Consider two polar cases:
1. Individuals see that they have $Y less to spend in all
other goods and adjust accordingly
2. Individuals think of $Y as depleting their grocery
budget specifically, and they may spend $Y less on
their next trip to the grocery store or they may
never change consumption and instead simple end
up saving less
5
THE PITFALLS
1. Can the number of potential psychological factors be made
manageable?
‐ For any policy problem, it seems that an endless array of
psychological phenomena could be relevant
‐ Solution: Abstraction

2. Does imperfect optimization make welfare economics

impossible?
‐ Behavioral model: Choices no longer reveal preference
‐ The failure of revealed preference deprives public sector
economics of a clean analytical foundation for assessing the
welfare impact of policies

6
‐ Solutions:
a. Observe practical reality.
‐ The role of most public finance economists is to design
policies that take welfare functions as given.
‐ We do not expect economic theory to resolve
interpersonal conflicts

b. Observe a misleading aspect.

‐ Example: Cigarette
‐ The only reason for government to intervene is to solve
a behavioral problem
‐ In sharp contrast, most policies aim to solve
nonbehavioral problems
‐ The issue of welfare, while not disappearing, becomes
secondary
7
THE PAYOFF
1. Perceived prices drive behavior
‐ Standard public finance emphasizes the use of price changes,
through taxes and subsidies, for example, to attain efficiency
‐ Behavioral Public Finance recognizes that Psychology
mediates consumers’ responses to prices
‐ Example: limited attention and limited computational
capacity

2. Nudges have social as well as private effects

‐ Example: Temporary Assistance to Needy Families (TANF) or
Medicaid
‐ One must understand how nudges interact with the market
failures that motivated the nudge policy and evaluate them
within the broader social welfare function
8
3. The social welfare function has psychological aspects
‐ Example: Social Security

4. Unintended behavioral responses to policies do not

necessarily represent moral hazard
‐ Example: Unemployment

5. Selection effects reflect both incentives and psychology

‐ Individuals can respond to incentives in nonstandard
ways that can undo or reverse selection effects
‐ Example: When the government seeks to induce efficient
screening which arises in targeted transfer programs

6. Government intervention is more effective when attuned to

the market’s choice architecture

9
‐ Regulations, taxes, or subsidies that better align firm
profits with true utility mean that markets can be used to
solve behavioral biases
‐ Careful policy can harness market forces to resolve
behavioral biases

10
II.
Psychology
and
Economics
11
THREE BASIC DEVIATIONS
FROM STANDARD
ASSUMPTION
1. Imperfect Optimization
2. Bounded Self-Control
3. Nonstandard Preferences

12
IMPERFECT OPTIMIZATION
× The classical model assumes that individuals are optimal
decisionmakers.
× However, according to Psychology and Behavioral Economics,
individuals are, in practice, flawed decisionmakers.
× Illustration: Increase in the number of alternatives
➢ Standard assumptions: increasing the no. of elements in a
choice set should leave individuals at least as likely to
choose from the set of increased choices as to choose from
the original set
➢ Experiment: shoppers in a grocery store –individuals
offered the larger set of samples were actually put off from
choosing by the difficulty of selecting from the greater
numbers of options 13
Three Deviations:
1. Limited Attention
- Individuals have a limited capacity to attend to multiple
features of choice simultaneously
- Individuals ignore some features of choice and are
excessively sensitive to others, depending on the extent to
which those features attract attention
- Individuals construe their choices in artificially narrow
terms as they direct their attention across the features of
choices, leading to locally rather than globally optimal
choice

14
Set of effects of limited attention on choice:
a. Salience Effects –more salient features of choice get
access to the limited attention of decisionmakers, while
less salient features do not

b. Local Construal -individuals may focus on immediate or

salient outcomes rather than the full range and path of
outcomes

15
 2. Limited Computational Capacity
‐ Individuals can find some choices hard to make because of
the complexity of evaluating the alternatives and because
they are unbounded in their capacity to think and reason
‐ Optimization generally is only approximate, not accurate
or precise

Specific classes of choice anomalies:

a. Decisional Conflict –Individuals appear to find the process of
choosing itself to be difficult under some conditions
‐ “choice overload” ; difficult choices

b. Inconsistent Subjective Valuation –Valuations of positive and

negative attributes of alternatives differ depending on whether
individuals are selecting or rejecting alternatives
16
 ‐ Individual’s preferences can be influenced by external cues that
have no plausible connection to subjective value
‐ Preferences appear to be very sensitive to the way in which
choices are structured

c. Schmeduling –a tendency of individuals to hold and act on only

approximate mental representations of price schedules

d. Mental Accounting and Choice Bracketing

- Mental accounting: the tendency of individuals to evaluate
choices with respect to discrete, notional accounts rather than
general measures of financial status
- Affect how individuals make choices about the time path of
consumption, payment, and debt, depending on how individuals
form the respective accounts 17
 ‐ Choice bracketing: Individuals can choose to use broader or
narrower brackets, and the bracket used will have an impact on
choice

3. Biased Reasoning
‐ Individuals exhibit biases when accessing the probabilities
associated with risky choice or when making judgments about
their own place in the distribution of possible outcomes
‐ “inaccuracy”

Two broad categories:

a. Probabilistic Reasoning –Individuals appear to have difficulty making
correct or consistent decisions under uncertainty

18
 ‐ “availability heuristic” ; “representativeness heuristic”
‐ Individuals appear to systematically overweight low
probabilities and underweight high probabilities in
decisionmaking

b. Motivational Biases –biases in probability assessments related to

individual’s chances if success in their own endeavors
‐ “overconfidence” ; “over-optimism ; “self-serving bias”

19
BOUNDED SELF-CONTROL
× The classical model assumes that individuals are good at implementing
their choices.
× However, Behavioral Economists found that individuals can have
difficulty doing what they want.
× Individuals choose and act in ways that are time-inconsistent, and they
often display a bias for present over future consumption
× Translating intention into action seems to involve difficulties that te
standard model does not allow for and results in behaviors that it does
not predict and cannot easily accommodate.

20
Classes of Behavior:
1. Procrastination and Temptation
‐ Procrastination: failing to take actions that they intended to
take
‐ Temptation: taking actions from which they intended to refrain
‐ “commitment devices”

2. Channel Factors
‐ Explain the tendency of individuals to be steered toward or away
from choices by ostensibly quite minor barriers or inducements

3. State and Affect

‐ The ability of individuals to exhibit self-control depends not just
on the context of choice but also on the state of decisionmaker

21
Two ways in which state and affect can influence the ability of
individuals to take actions that match their intentions:
1. When individuals find it difficult to exert self-control, other
aspects of their mental state can modulate their ability to
overcome that difficulty

2. State and affect can play a role in time-inconsistent behavior

to the extent that the inconsistency comes about because of
the difficulty that individuals have in predicting their hedonic
state, or forecasting their affect, at the time of forming their
intentions
‐ “projection bias”

22
4. Addiction
‐ A process by which individuals lose the ability to
maintain self-control
‐ A matter of substances or behaviors leading to a direct
interference with the ability of the brain o forecast
hedonic states

23
NONSTANDARD PREFERENCES
× 2 weak assumptions about the shape and content of
preferences:
1. Individual utility is a function of end states.

2. Individuals are purely self-interested.

× Both cases are standard simplifying assumptions.

24
Types of Nonstandard Preferences:
1. Reference-Dependent Preferences
‐ Individuals appear to evaluate many choices in relative
terms, in particular in, comparison with some reference
point
‐ Preferences over alternatives might depend on:
a. Whether an alternative represents a gain or loss relative to
expectations or to prior experiences
b. Whether individuals are valuing a good to sell it or to buy it
c. Their relationship to the status quo

Consequences of Nonstandard Preferences:

a. Endowment Effect –where individuals start from, in terms
of endowment, matters for choice because it creates a
reference point that affects how they value outcomes
25
b. Loss Aversion –Individuals do not value or experience
losses and gains symmetrically
‐ Individuals perceive losses more intensely than gains
‐ Consequences:
i. Individuals can make choices that reveal an extreme
aversion to risk
ii. Individuals may be willing to accept risk in order to
avoid greater losses

c. Status Quo Bias –The tendency of people to stick with

what they have

26
2. Other-Regarding Preferences
‐ Individual preferences are related to the choices and
outcomes of others

Facets of Other-Regarding Preferences:

a. Altruism –People frequently act as though they care
about the outcomes of others, either individually or as
a group
- Consequences:
i. Voluntary redistribution
ii. Voluntary contributions to public goods

27
b. Fairness –Individuals have preferences with respect to the
process that generates outcomes, as well as the outcomes
themselves

c. Social Norms –Individuals are influenced by the behavior of

others and by the way that others expect them to act

d. Interpersonal Preferences –People care how they are

viewed by and how they are positioned relative to others
‐ Consequences:
i. An individual’s utility is a function of their outcomes
relative to the outcomes of others
ii. Individual choices depend to some extent on how
individuals identify socially
28
III.
Behavioral
Economics and
Public Finance
29
PUBLIC FINANCE
➢ the study of the role of the government in the economy
➢ develops guidelines for designing policies that addresses
the conditions under which unregulated markets lead to
inefficient or undesirable outcomes.
➢ Public finance economists work to understand what is
wrong with the economy when markets fail and how to
use the apparatus of the state to improve social
outcomes

30
 Behavioral
economics
change the way
that public
finance treats
policy problems
 Ways on revising public finance standard conclusions

• Diagnosing Policy Problems

• Judging Policy Objectives
• Prescribing Policy Problems

32
Diagnosing Policy Problems
1. Behavioral tendencies may change the way that
policy problems related to both market efficiency
and economic equity translate into welfare
outcomes
2. Behavioral tendencies may also in some cases
create the underlying conditions of a market failure
directly

33
Diagnosing Policy Problems
Market Failures
1. Asymmetries of Information
ex. health insurance markets

Modify the assumption that individuals choose optimally according

to their private information
Therefore, the interaction between asymmetric information
and behavioral tendencies makes the consequences od
asymmetric information for market outcomes and the
nature of the resulting policy problem much less certain

34
Diagnosing Policy Problems
2. Externalities and public goods
ex. consumption on gasoline
-Psychology at work might cause individuals to make
different choices
-the welfare costs of externalities may be either mitigated or
exacerbated by the presence of behavioral tendencies.
- Behavioral economics does not in every case justify more
government intervention

35
Diagnosing Policy Problems
Poverty and Inequality
-Nonstandard preferences change both the presumed shape
of individual preferences as well as the arguments that enter
the utility function
-welfare losses due to inequality or poverty may be larger or
smaller due to behavioral tendencies
- The way in which inequality translates into welfare costs is explicitly a
function of preferences (eg. preferences for fairness)
- Behavioral issues on poverty is more likely on the imperfect optimization
and bounded self-control

36
Diagnosing Policy Problems
Taxation and Revenue
-government raise revenue to support its functions
-there is an important behavioral dimension to what the
government should do in response to raising revenue
-raising revenue optimally involves weighing the efficiency
costs of taxation against the benefits of raising revenue, and
the terms of the trade-offs depend on how individuals
respond to taxes.

37
Judging Policy Objectives
× Requires judgments on the part of society and
policymakers
× However, public finance can only identify those
judgements
× Imperfect optimization, bounded self-control, and
nonstandard preferences all may modify the effects of
policy and the way in which alternative policy regimes
are traded off for one another.

38
Judging Policy Objectives
Policy Trade-Offs
1. Moral Hazard
- Arises when individuals protected by policy from the full negative
consequences of some adverse state face diminished incentives to avoid
such conditions or to escape them.

-Policy must determine how much moral hazard the society

is willing to tolerate
-the effect of behavioral tendencies may be to either
mitigate or exacerbate moral hazard

39
Judging Policy Objectives
2. Optimal Taxation
-Raising revenue through taxation creates distortions in the
markets
-tax policy must reflect judgments about what efficiency
consequences of taxation are worthwhile and how to
equitably distribute the burden of taxation

It is worth noting that behavioral economics creates

something of a paradox requiring more of policymakers
while suggesting that they are too behavioral agents.

40
Judging Policy Objectives
Welfare Weights
How should policy address the possibility that individuals
make choices that are in error, that represent a failure of
self-control, or that are inconsistent?
-Policy must reflect judgments about which preferences to
favor and to what degree
-the policy judgments introduced by behavioral economics
involve setting policy in ways that resolve intrapersonal
preference conflicts.

41
Prescribing Policy Responses
Three insights to policy design
1. Using prices and incentives to affect and manage
behavior
2. Ability of policy to manage and use private information
to achieve policy goals
3. The use of markets and choice architecture to achieve
policy goals in general equilibrium

42
Prescribing Policy Responses
Prices and Incentives
-when policymakers seek to change market outcomes, they
can change prices
-however, behavioral approach to policy design suggests a
less straightforward relationship between prices and
behavior.
1. Response to Prices
- Psychological forces tend to mean that prices will not be as
uniformly effective in driving behavior

43
Prescribing Policy Responses
2. Nonprice Levers
Nudges – features of policy that operate directly through
the behavioral tendencies that individuals exhibit in order to
elicit a response.
ex. influence of social norms in energy consumption

It is also important to note that prices and nudges also

operate interdependently

44
Prescribing Policy Responses
Information and Screening
Screening effect- whom incentives impact and what the mix
of responses is rather than their overall impact
-Behavioral approach complicate the relationship between
incentives and selection substantially
ex. government screening in targeted transfer programs

-the interaction of behavioral tendencies with selection

effects can sometimes create opportunities for policy

45
Prescribing Policy Responses
Markets and Choice Architecture
-policy can harness the general equilibrium properties of
markets to ensure desirable outcomes
-however, in behavioral model, people may not choose
optimally, and that has consequences for market outcomes
-markets do not necessarily respond to policies intended to
change market outcomes

46
Thanks!

47