Richard Thaler’s Rejoinder to the TOTM Free to Choose Symposium

Josh Wright —  13 December 2010

Editor’s Note: I invited Professor Thaler to respond to the TOTM Free to Choose Symposium, and he graciously accepted and offered the following response.

Richard Thaler is the Ralph and Dorothy Keller Distinguished Service Professor of Behavioral Science and Economics at the University of Chicago Booth School of Business.

I have now had a chance to read through the contributions to this event and have a few thoughts to share.  I cannot, of course, reply to everything that has been said here, and in any case, most of what I would say already appears in print.  Before getting into specifics let me say one thing up front:  take a deep breath!  These posts have a lot of emotion.  I am not sure why.

On to specifics:

  1. It is simply unscientific to ignore empirical evidence and theoretical progress.  Take prospect theory, for example. This is Kahneman and Tversky’s descriptive model of decision making under uncertainty published in Econometrica in 1979, and one of the most frequently cited papers in all of economics.  There is simply no doubt that prospect theory is much better at describing behavior than expected utility theory, both in the lab and in the field.  See Colin Camerer’s paper Prospect Theory in the Wild, for example.  At some point I am sure that a better theory will come along, but for now this is the best one we have.  I teach my students that they should strive to obey the axioms of rational choice and thus be expected utility maximizers, but if they are trying to predict what someone will do, use prospect theory.  No one who is really familiar with the literature could seriously disagree with this advice.  Isn’t this just good science?
  2. As one of the contributors pointed out, Christine Jolls, Cass Sunstein and I defined behavioral economics as simply economics with a higher R squared.  There is nothing radical or explicitly political about this research agenda.  The question is also not whether people are “rational”, a word I try to avoid. Rather, the question is about the descriptive validity of rational choice models. Cass and I use the terms Humans and Econs to distinguish between “people” and the imaginary creatures who obey the axioms of rational choice.  The evidence is, unsurprisingly, that the world is populated mostly by Humans, not Econs.  For several years I wrote a series of articles in the Journal of Economics Perspectives on Anomalies.  (The early ones are collected in my book The Winner’s Curse.)  I wrote 19 of these columns and quit only because I got tired.  This is simply not a debatable point any more.  I find it amusing to think that the great paper written by Armen Alchian years before any of this evidence became known is still the best reply.
  3. The notion that behavioral economics is primarily based on laboratory data was never very accurate and has been wildly offbase for at least 20 years.  For example, of the 19 Anomalies articles, only 5 are based on lab studies, the rest rely on so-called “real world” data, many from financial markets.  This is not to say that the findings in the laboratory should be dismissed, a notion that physicists would find laughable.  Behavioral economics is now a field that relies on a multitude of empirical methods, and I am happy to say that most of the most important findings, such as loss aversion and overconfidence, have been confirmed in numerous different domains using lots of different methods.
  4. Many of the posts reflect some confusion about the role behavioral factors in competitive markets.  This is a subject that behavioralists have been writing about for 25 years.  Three early papers published in 1985 set the stage:  Akerlof and Yellen (QJE), Haltiwanger and Waldmann (AER) and Russell and me (AER). These were followed by the very influential series of papers on “noise traders” by De Long, Shleifer, Summers, and Waldmann and then by Shleifer and Vishny.  See Shleifer’s book Inefficient Markets.  The bottom line of all these papers is that noise traders, or Humans, do not disappear in markets, nor do they leave markets unaffected by their presence. An important point that many critics seem to misunderstand is that markets do not tend to eliminate less than fully rational behavior; rather, they will often cater to it.  For example, if people are too risk averse for small stakes, which Matthew Rabin has shown to be inconsistent with expected utility theory, then firms will try to sell them extended warranties.  What happens then?  It may come as a surprise to Judd Stone, but many of us have thought and written about this question.  Stone writes as follows:

“Unless behavioralists can demonstrate – or even articulate! – some reason to believe that firms (1) remain sufficiently rational to predate upon consumer biases, yet (2) despite this rationality will not compete the monopoly profits of those biases away – I echo several other contributors’ insights that the leap from behavioral quirk to public intervention is something of a non sequitur.”

Let’s examine his two questions in the context of the extended warranty question.  Suppose that narrow bracketing plus loss aversion induce consumers to be willing to pay $100 for an extended warranty that has an expected value to them of $50, and take my word for it that Rabin can shown that if you do this you will agree to other exchanges that look very, very dumb (such as turning down a 50-50 chance to lose $1000 or win a billion dollars).  It does not take a stroke of genius for some firms to figure out that you can make some money selling this type of insurance.

Now let’s introduce some competition.  Competition will drive the price of this insurance down to a competitive rate of return for sellers, but this does not at all mean that consumers are prevented from doing something dumb.  Say the competitive price is $90.  (It is very expensive to sell this kind of insurance, one policy at a time, and divvy up the profits among the insurance company, the store where the product is purchased, and the sales clerk who is rewarded for pushing it.)

The point is that we can easily have an equilibrium in which consumers are buying something that economists would recommend they not buy, and that they would not if they were expected utility maximizers.  Now, as I must have written and said thousands of times over the past 30 years, this story does not in any way imply a role for regulation, nor if there is, what form that regulation should take.  All the story does is reveal that, exactly contrary to what Stone and many other of the contributors imply, the case for laissez faire is somewhat weakened.  It is no longer possible to make the lazy laissez fare argument that nothing can go wrong in competitive markets, or that Humans always choose what is best for them.

Consider the recent financial crisis.  As we know, many of the troubles started with sub-prime mortgages.  These mortgages were often sold door to door, much like home vacuum cleaner systems in earlier times.  The mortgage brokers who worked this market were rewarded based on how many mortgages they sold, and how profitable those sales were.  Keeping in mind that in this segment of the market there is little repeat business, what should we predict about the truthfulness of the salespeople?  Clearly one plausible equilibrium is that the most deceptive salesman wins the biggest share of the market.  Competitive markets plus badly aligned incentives create a race to the bottom by mortgage salesmen.  And it is well documented that many borrowers chose badly.

5.  Okay, so now let’s talk about the thing that everyone seems most concerned about, regulation.  Let’s take my mortgage example seriously and ask what the new CFPA should do if the market is as I describe it.  The traditional tools of the regulator are to ban some products and require disclosure for others.  What would I suggest if Elizabeth Warren asked for my advice?  The first principle is to realize that regulators are Humans too.  As I wrote in one of my New York Times columns (in an article about World Cup refereeing), Professor Warren would be well advised to assume that there will eventually be a nitwit heading this office for a while. So, as Larry Summers said recently, we do not want financial regulations that require that anyone has to get any smarter.  The next principle is to recognize that choosing a mortgage is complicated, and to state the obvious, Humans do better at easy tasks than hard ones.  People are pretty good at deciding whether they like ketchup or mustard on their hot dog, in part because they have been able to conduct trial and error learning.  Choosing a mortgage is both harder and done less often. Then the job of a regulator in a “complex” market is to help consumers make better choices (that is the choices they would make for themselves if they were fully informed and capable of doing all the math), while imposing as few costs as possible on both suppliers and sophisticated consumers.  Banning all but the simplest of mortgages would punish sophisticated borrowers who would benefit from some exotic vehicle.  Imposing big costs on lenders will make everyone worse off.  We get this!

My favorite idea (discussed at length in Nudge) for an intervention in this market would be to require that all disclosure rules be made electronic.  Instead of (or perhaps in addition to for a while) giving borrowers 30 pages of fine print that no one ever reads, borrowers would get an electronic file that details all the fine print in a spread sheet.  Consumers would then take that file and with one click upload it to competitive web sites that would analyze, compare and recommend alternatives to consumers.  Shopping for a mortgage would become more like shopping for a plane ticket.  The costs to lenders of complying with this regulation would be tiny, and the benefits would potentially be huge.

One thing to notice about this suggestion is that it is just trying to make the market work more like it would in the imaginary world in which choosing mortgages is as easy as choosing between ketchup and mustard.  It would make markets more efficient, and importantly, would shift the playing field to favor the honest lenders over the deceptive ones.  And it is all based on the important premise that Humans have limited information processing capabilities, a premise that I don’t think anyone can seriously question, especially those of us getting on in years.

6.  The idea that behavioral economists want to create some sort of new nanny state is preposterous.  Many leading behavioral economists, including me, have strong libertarian leanings.  Some are actually card-carrying libertarians.  Still, much of the criticism of the field comes from conservative, free-market economists who just “know” somehow that, no matter what we say, behavioral economists are part of some left-wing, probably communist, and certainly socialist conspiracy.  I am not sure how to convince anyone that this is not true. But here is what I really think.  The philosophy of libertarian paternalism that Cass and I advocate in Nudge, could accurately titled Free to Choose, 2.0.  If people would read with care what we have written, they will see that this is accurate.  We do not advocate a larger role for government, just a more efficient, smarter way of achieving a government’s goals, whatever the democratic process determines that they should be. Does anyone advocate dumber and costlier instead? Tom Brown made this point very nicely with his excellent illustrations of effective and ineffective communications efforts.

7.  Lastly, I can certainly not comment objectively about the role my friends and fellow travelers have played in the Obama administration, or what role behavioral economics has played.  What I will say is that the Obama administration has certainly not gotten enough credit, especially from free market economists and lawyers, for their solid improvements in transparency.  On his first day in office, President Obama issued an executive order mandating transparency as the “default option” for his administration.  It says, in part:

Government should be transparent.  Transparency promotes accountability and provides information for citizens about what their Government is doing.  Information maintained by the Federal Government is a national asset. My Administration will take appropriate action, consistent with law and policy, to disclose information rapidly in forms that the public can readily find and use. Executive departments and agencies should harness new technologies to put information about their operations and decisions online and readily available to the public. Executive departments and agencies should also solicit public feedback to identify information of greatest use to the public.

Additional steps taken in many branches of government have followed this order.  One only has to look at www.data.gov to see a portion of the evidence that in two years we have moved from the most secretive administration in our history to our most open.  I know of one firm, Brightscope, that provides ratings of company retirement plans.  In the past they had to request the data on each company one by one in some office in the Department of Labor.  Within six months of Obama taking office, they received a CD with all the data, allowing them to hire a bunch of new employees and rate hundreds more firms.  And here is a subtle point about just releasing data.  Several firms discovered they had terrible 401(k) plans because of a low Brightscope rating, and they have taken appropriate steps to improve their plans, for example by reducing fees.  Can we all agree that releasing data in machine readable form is better than locking reports in file cabinets?

So as I said at the top, take a deep breath.  The alternative to us is bans and mandates.  Of course I have no control over what people do with behavioral economics.  But if someone bans soda pop, cigarettes, or marijuana for that matter, don’t blame me.  If you appreciate having better data on what the government or your employer is doing, then please feel free to send the President a thank you note.

4 responses to Richard Thaler’s Rejoinder to the TOTM Free to Choose Symposium

  1. 

    As David Friedman notes above, Richard Thaler should be credited for a frank and articulate response to the various criticisms offered in the symposium. After reading the response, four points jump out to me as the most interesting:

    1. Perhaps the most important substantive part of the response, in my view, is Thaler’s rejection of the view of consumer credit regulation contemplated by the CFPB and its intellectual founders. The “plain vanilla” requirement in the CFPA (and still quite possible to achieve through the current CFPB through rules) and other actual proposals for the behavioral law and economics camp (e.g. banning credit cards, subprime mortgages, auto title loans used my small businesses) would impose significant costs on lenders and consumers who would be made better off from the availability of those products. Thaler writes:

    “Then the job of a regulator in a “complex” market is to help consumers make better choices (that is the choices they would make for themselves if they were fully informed and capable of doing all the math), while imposing as few costs as possible on both suppliers and sophisticated consumers. Banning all but the simplest of mortgages would punish sophisticated borrowers who would benefit from some exotic vehicle. Imposing big costs on lenders will make everyone worse off. We get this!”

    Excellent. From Thaler’s pen to Elizabeth Warren’s ears…

    2. There is an interesting tension between Thaler’s point #6 and the discussion of actual regulatory proposals purportedly based upon the insights of behavioral economics. On the one hand, Thaler writes that “The idea that behavioral economists want to create some sort of new nanny state is preposterous,” and that some behavioral economists are libertarians. On the other, Thaler discusses the CFPB regulations which would reduce consumer credit, bans on soda, sin taxes, etc.

    Those proposals are real. Those critiquing the regulatory manifestations of the BE movement are just creative. The proposals are real. Read Bar-Gill and Warren and others. Perhaps not so preposterous after all?

    3. To be fair, Thaler is making a distinction between BE and BLE, or at least, the proposals from those in the BLE literature. Its an appropriate distinction. Thaler doesn’t want to be blamed for what the BLE folks do with the work of behavioral economists. And its true that conventional economics has also been abused. BE has no monopoly on this front. But the distinction between BE and BLE is important. The regulations have to be applied by someone. Probably someone with cognitive biases. Maybe lots of people with lots of them. Further, to the extent that the gap between BLE and BLE is predictable (it is by now, isn’t it?), wouldn’t it be unscientific not to account for the full set of the costs and benefits of this approach? For example, what are the long term social costs of a regulatory approach that infantilizes “unsophisticated” consumers by nudging them toward choices that the regulator knows will make them “better off according to their own preferences”?

    4. Free to Choose 2.0 or Not? Relatedly, Thaler writes that “If people would read with care what we have written, they will see that this is accurate. We do not advocate a larger role for government, just a more efficient, smarter way of achieving a government’s goals, whatever the democratic process determines that they should be. Does anyone advocate dumber and costlier instead?”

    This well may be true for some of what Thaler and Sunstein have proposed. But even holding aside the proposal of folks in the BLE literature that Thaler et al disagree with and focusing exclusively on his own work, its not all veggies at the front of the cafeteria. Rizzo & Whitman have pointed much of this out. But for just one example, consider Thaler’s proposal to replace the employment at will default with one allowing termination “for cause.” “Choice” to invoke “at will” is preserved only for those willing to pay a penalty. This is more than just a leaner and meaner and more effective government and to suggest otherwise is misleading.

  2. 

    I’d like to start out by thanking Professor Thaler for his response; Professor Thaler raises several thoughtful points about the role of competition in eliminating, reducing, or exploiting biases of irrational consumers. I nonetheless note that on Southwest Airlines, bags fly free. Please allow me to explain.

    Professor Thaler notes that the case that lassiez-faire competition is “somewhat weakened” by the prospect of firms peddling products that essentially deceive behaviorally biased consumers: a warranty, for example, that isn’t as reliable or robust as consumers might expect ex ante on account of, for example, optimism bias. In the context of a larger post about some issues at the intersection of behavioral economics and administrative regulation, I made a brief point that this assumption requires two conditions precedent: rational firms (even though they are comprised of irrational humans), and that rational firms’ competition will not whittle away supra-competitive profits from these behavioral biases. Professor Thaler points out that competition will narrow the gains from this behaviorally-inspired negative value product, but that this reduction has nothing at all to do with whether or not consumers purchase the negative-value product in the first place. As such, there is one plausible equilibrium where the most deceptive salesman (or engineer, or product designer, for that matter) wins the biggest share of the market.

    What I would respectfully submit this narrative overlooks is the dynamics of competition. Consumer misperceptions and errors in valuing terms like warranties or other hidden frees are not exogenous. Indeed, the larger the gains from trade from individual firms in exploiting these errors, the larger the potential for competing firms to educate behaviorally-biased consumers in order to steal market share! When one or more companies in a market have the potential to gain from the conscious, systematic exploitation of consumers due to behavioral biases and those biases impose disproportionate costs on consumers in exchange for a competitive rate of return, we would expect a firm in the market to point that out in order to gain market share. There are already several real-life examples of this phenomenon: hence my comment that on Southwest Airlines, bags fly free — a fact we only know and recognize specifically because Southwest engineered an advertising campaign designed to increase its market share by pointing out (somewhat glibly) that airlines’ unbundled pricing was raising costs on consumers.

    Professor Thaler is certainly correct that we would observe different bundles of contract terms with rational consumers than one would observe with completely irrational or even somewhat rational consumers. This is because competitive activities will be concentrated on those dimensions and contract terms that consumers can rationally comprehend and price. Assume Professor Thaler’s warranty. Let us also continue to assume a competitive, zero-profit equilibrium. One would assume we would begin seeing Firm X and Firm Y compete on price terms as well as the behaviorally-conceived warranty term. Y can afford to bid down the base price of the product beneath the competitive price that would prevail with consumers that rationally valued both price and warranty, knowing that warranty revenues will cover some of the losses at the margin. X will respond, and so on. The point is that we would of course expect to see different contractual terms in a market with rational consumers as irrational ones; what is less obvious is that either world evinces a market failure or consumer harm of some sort. In fact, in the hypothetical outlined above, we would predict a lower-quality warranty (at a higher price) but also lower prices for the product itself which would clearly offset consumer losses from the reduced quality of the warranty. It is unclear consumers are worse off in this world when competition across all terms is taken into consideration, including non-behavioral terms behaviorally-biased consumers could nonetheless rationally evaluate, except in the Nirvana Fallacy sense of the term.

    Consumers do inquire as to bag fees. Warranties and products can be purchased unbundled from one another. When firms attempt to exploit behavioral biases, in a competitive equilibrium, other firms will attempt to point these out to gain market share (see also: “Bags Fly Free,” “Keep the Change,” “No Hidden Fees For Booking at” any number of travel sites, etc.). Perhaps in some cases this form of competition does not reduce inefficiency to zero, but it certainly reduces it if it does not eliminate it. And this form of competition suggests that regulators are not only aiming at a target that is much smaller than if one focuses exclusively on the warranty term, but also a target that moves as competitive forces provide incentives for firms to educate consumers and improve decision-making. When we fail to see this competition, I would submit that we must first closely scrutinize the indispensible assumption that the product we’re seeing is actually of negative value to the consumer, rather than merely to the observer, or to the regulator.

  3. 

    I want to thank Professor Thaler for an articulate, honest, and in some ways persuasive response. As I told Cass Sunstein during the election, he might not be a libertarian in a strong sense of the term but he was arguably more libertarian than the then current presidential candidate of the Libertarian Party.

    I think, however, that there is still a serious problem with your argument, one which parallels the problem with the old pro-government economic arguments of the 1960’s. Those arguments applied reasonable assumptions to the market but assumed that the alternative was a government which, given the power, would simply use it to do the right thing.

    Your version is more sophisticated than that. You recognize that Elizabeth Warren’s successor might be a nitwit. But you ignore the much more likely possibility that he will be a politician. The question to which I do not think you have given adequate attention, at least judging by this essay, is the degree to which the ideas you are arguing for, implemented not by you and people like you but by Congress and the President and the people they will appoint, can provide plausible excuses for policies you would disapprove of.

    Much of what your arguments imply is control by government over how information is presented. Used as you recommend, to lower information costs to consumers, that could indeed be a good thing. But it is not hard to imagine other ways in which it could be used which would be more politically profitable and would produce less desirable outcomes. The ability to compel producers of a legal product to include with it highly emotive images advertising how bad it is—I am thinking of current proposals with regard to cigarettes–is a tool that can be used both to distort consumer choices in a (non-libertarian) paternalist direction and, as a threat, to control or extort firms. Control over how information about new products is presented could be very useful to the producers of the old products with which the new compete.

    What incentive compatible mechanisms do you propose to keep the regulators honest?

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