Behavioral Economics and Public Policy: A Pragmatic Perspective

The debate about behavioral economics – the incorporation of insights from psychology into economics – is often framed as a question about the foundational assumptions of economic models. This paper presents a more pragmatic perspective on behavioral economics that focuses on its value for improving empirical predictions and policy decisions. I discuss three ways in which behavioral economics can contribute to public policy: by offering new policy tools, improving predictions about the effects of existing policies, and generating new welfare implications. I illustrate these contributions using applications to retirement savings, labor supply, and neighborhood choice. Behavioral models provide new tools to change behaviors such as savings rates and new counterfactuals to estimate the effects of policies such as income taxation. Behavioral models also provide new prescriptions for optimal policy that can be characterized in a non-paternalistic manner using methods analogous to those in neoclassical models. Model uncertainty does not justify using the neoclassical model; instead, it can provide a new rationale for using behavioral nudges. I conclude that incorporating behavioral features to the extent they help answer core economic questions may be more productive than viewing behavioral economics as a separate subfield that challenges the assumptions of neoclassical models. ∗Prepared for the Richard T. Ely Lecture, American Economic Association, January 3, 2015. A video of the lecture is available here. I thank Saurabh Bhargava, Stefano DellaVigna, Nathaniel Hendren, Emir Kamenica, Lawrence Katz, David Laibson, Benjamin Lockwood, Sendhil Mullainathan, Ariel Pakes, James Poterba, Matthew Rabin, Josh Schwartzstein, Andrei Shleifer, and Dmitry Taubinsky for helpful comments and discussions. I am very grateful to my collaborators John Friedman, Nathaniel Hendren, Lawrence Katz, Patrick Kline, Kory Kroft, Soren Leth-Petersen, Adam Looney, Torben Nielsen, Tore Olsen, and Emmanuel Saez for their contributions to the studies discussed in this paper. Augustin Bergeron, Jamie Fogel, Michael George, Nikolaus Hildebrand, and Benjamin Scuderi provided outstanding research assistance. This research was funded by the National Science Foundation. Starting with Simon (1955), Kahneman and Tversky (1979), and Thaler (1980), a large body of research has incorporated insights from psychology – such as loss aversion, present bias, and inattention – into economic models.1 Although this subfield of “behavioral economics” has grown very rapidly, the neoclassical model remains the benchmark for most economic applications, and the validity of behavioral economics as an alternative paradigm continues to be debated. The debate about behavioral economics is often framed as a question about the foundational assumptions of neoclassical economics. Are individuals rational? Do they optimize in market settings? This debate has proved to be contentious, with compelling arguments in favor of each viewpoint in different settings (e.g., List 2004, Levitt and List 2007, DellaVigna 2009). In this paper, I approach the debate on behavioral economics from a more pragmatic, policyoriented perspective. Instead of posing the central research question as “are the assumptions of the neoclassical economic model valid?”, the pragmatic approach starts from a policy question – for example, “how can we increase savings rates?” – and incorporates behavioral factors to the extent that they improve empirical predictions and policy decisions.2 This approach follows the widely applied methodology of positive economics advocated by Milton Friedman (1953), who argued that it is more useful to evaluate economic models on the accuracy of their empirical predictions than on their assumptions.3 While Friedman used this reasoning to argue in favor of neoclassical models, I argue that modern evidence calls for incorporating behavioral economics into the analysis of important economic questions. I classify the implications of behavioral economics for public policy into three domains. Each of these domains has a long intellectual tradition in economics, showing that from a pragmatic perspective, behavioral economics represents a natural progression of (rather than a challenge to) neoclassical economic methods. First, behavioral economics offers new policy tools that can be used to influence behavior. Insights from psychology offer new tools – such as changing default options or framing incentives as losses instead of gains – that expand the set of outcomes that can be achieved through policy. This expansion of the policy set parallels the transition in the public finance literature from studying Although the implications of psychology for economics have been formalized using mathematical models only in recent decades, some of these ideas were discussed qualitatively by the founders of classical economics themselves, including Adam Smith (Ashraf, Camerer and Loewenstein 2005). I focus on factors that can be changed through policy, but much of the analysis in this paper also applies to predicting the effects of changes in other exogenous factors, such as technology. In a widely cited example, Friedman points out that the behavior of an expert billiards player may be accurately modeled using complex mathematical formulas even though the assumption that the player himself knows and applies these formulas is likely to be incorrect.