Teaching an Old Government New Tricks: (How) Can the Public Sector Take Advantage of the Biggest Change in Economic Thinking of Our Generation?

Article excerpt

More than ten years ago, Sweden, a country known for its comprehensive social welfare policy, privatized part of its social security system. This new, private system developed by economists allowed participants to design their own social security portfolio from the 456 different options offered. Recognizing that many citizens would accept the status quo portfolio, the Swedish economists carefully created a well-designed and diversified default option. They also attempted to overcome this "status quo" bias by encouraging citizens to choose their own policies through extensive television, billboard, and radio advertising.

The Swedish economists' goal of crafting a balanced default option while encouraging citizens to attempt to choose for themselves backfired. The advertising campaign framed social security as a way for citizens who hadn't saved enough to "catch up." Two-thirds of the 4.4 million eligible adults were sufficiently motivated to design their own portfolio in the first year of the programi. However, despite mailed educational material, they chose in a predictably irrational way. Primed with a view that this was a way to move from behind the pack to out in front, citizens inadvertently became risk seeking and selected funds with a high three-year historical average return, low international diversification, and high hidden fees. The lack of diversification resulted in significant losses when the "tech bubble" burst shortly after. This policy illustrates the power--and the peril--of implementing what could be the most influential addition to our economic policy arsenal in over a generation: behavioral economics.

WHAT IS BEHAVIORAL ECONOMICS?

Economics is the analysis of individual and collective decision making. Economists aim to maximize overall utility by looking at incremental decisions (by reviewing marginal costs and benefits) and by assessing any impacts outside the parties involved (externalities). Policy makers use economics to adjust the costs and benefits to maximize overall utility in almost every realm of society. Economics informs policies on issues as diverse as corporate regulation, environmental policy, health care, and education reform. Classical economists view people as rational, utility-maximizing actors. Individuals know what they want and are consistent, methodical, and emotionless in pursuing it. Behavioral economists, on the other hand, tend to see people as swimmers of varying ability, being pulled in certain directions by tidal currents. These currents can be societal norms, personal emotions, or decision-making rules of thumb, known as "heuristics." Behavioral economics combines the insights from lab experiments on decision making and the findings of psychological field research into real-life behavior. The existence of these "cognitive biases" is a profound challenge to the "rational actor" model of orthodox economics. It suggests that many of the assumptions used by policy makers in structuring their incentives may not be true in practice.

HOW BEHAVIORAL ECONOMICS CAN CREATE PUBLIC VALUE

Understanding when and why people deviate from the "all people always act rationally" assumption can highlight cost-effective ways of changing individual decisions to promote public value. It can also help avoid policy that is inadvertently exaggerating decision-making biases that unchanged could result in large economic costs. Behavioral economics can therefore help design better policy, achieve better outcomes, and cut wasteful incentives.

One example of how using behavioral economics can create public value is through an "opt-out" scenario. In the case of choosing whether to enroll in a 401(k) plan when starting a new job, classical economists may argue that individuals will make the rational decision to enroll, since there is a very small cost to ticking a box; the selection an individual makes should be the same whether the default on the form is to opt in or to opt out. …