WAEA Keynote Address Behavioral Environmental Economics: Money Pumps & Nudges

Article excerpt

Herein we explore how money pumps from rational choice theory and nudges from behavioral economics work toward helping create better environmental policy. We examine the role of money pumps in environmental policy, and whether policymakers can use nudges to "supercharge" incentives. We summarize insight that has emerged from both camps in the areas of conflict/cooperation and mechanism design.

Key words: behavioral economics, conflict, cooperation, incentives, mechanism design, money pumps, nudges

Introduction

For the last twenty-five years I have worked on understanding the behavioral underpinnings of environmental policy. My work has explored how institutions, incentives, and nature interact, with the goal of finding tools to help provide environmental protection at lower cost. The research revolves around a Rule of One: one rational person can move society toward predicted market equilibria; one irrational person can move a game away from the predicted game-theoretic equilibria (Shogren, 2006). This razor's edge matters for environmental policy because society allocates these resources in a sphere of missing markets or no markets at all. We cannot necessarily rely on one rational person-fictional or representative-in a market to move society closer to efficiency if allocation decisions involve strategic interactions without markets. Assuming rational behavior for environmental policy is problematic when nature's goods and services lack the active market-like arbitrage needed to encourage consistent choice. Instead, we might need to revisit whether rational choice theory remains the most useful guide for understanding efficient environmental policy, a point long stressed by Jack Knetsch (1990). Perhaps the lessons emerging from the field of behavioral economics should play a bigger role in our work (e.g., Tversky and Kahneman, 1986). The practice of using rational choice theory to model decisions is vulnerable without the social context that either rewards consistent choice or overcomes any inconsistent choices in aggregation (Arrow, 1987).

My research focuses on creating the missing institutional context, or "money pumps," to create rational choice rather than on documenting biases and heuristics. These institutions are designed to help people help themselves by learning what it means to be the rational agents we presume inhabit our models (e.g., Cherry, Crocker, and Shogren, 2003). We designed these money pumps to either extract resources from inconsistent decisions or to lower the transaction costs of consistent decisions. We made no presumptions on optimal preferences, and we did not presume to know what was best for the decision maker. If a person decides if he or she likes more money to less after she has been run through the money pump, we have increased the consistency of choice closer to the assumptions. The money pump itself does not care about optimality. In this light, we were less interested in documenting "behavioral failures" than in understanding how institutional context sharpens behavior. If we can create an institution that allows one rational person to drive society toward efficiency, perhaps we can better understand the power and limits of market-like arbitrage mechanisms to remove biases, heuristics, aversions, and limits that exist in social interactions (Shogren and Taylor, 2008; Metcalfe and Dolan, 2012; Shogren, Parkhurst, and Banerjee, 2010).

While I was busy building institutions, behavioral economists blew past me. They identified more and more behavioral failures we can cluster into three broad self-explanatory categories: bounded rationality, bounded willpower, and bounded self-interest (Mullainathan and Thaler, 2000). Behavioral failure reflects the idea that when people behave differently than rational choice theory assumes, resources can be inefficiently allocated. I use the term behavioral failure to draw parallels to the familiar economic idea of market failure and inefficiency and to stress the normative notion in behavioral economics that society can "fix" these failures given some third-party expert who knows the optimal outcome and can create cues and nudge people toward that outcome (Thaler and Sunstein, 2008). …