The July/August 2021 Cato Policy Report hosted a friendly issue between Cass Sunstein and Mario Rizzo.
Sunstein is a Harvard Law professor, the onetime member of the Obama administration, and coauthor of Nudge and other books advocating public policy applications of behavioral economics.
Rizzo is an economist at New York University.
Sunstein argues that modifying the “ choice architecture” accessible to consumers so as to “ nudge” them toward the correct options are a libertarian position properly compatible with Friedrich Hayek’s The Constitution of Liberty.
Rizzo disagreed, arguing that behavioral economics does not solve Hayek’s knowledge issue, quoting psychologist Jerome Kagan’s 2012 guide: “ Few psychological ideas intended to represent a person’s tendency to react in a specific way apply across varied settings. ”
In other words, we do not know enough psychology to know just how people will react in each choice situation. Kagan did not write about behavioral economics, however as we will see, his booking applies there with special force.
The particular “ knowledge problem” manifests itself in many places in this short debate; I will mention just one: Sunstein’s frequent technique undefined term “ epistemically favorable conditions, ” which seems to mean conditions under which people will function “ rationally” — which of course presupposes the kind of knowledge that Kagan and Hayek dispute.
We cannot in general know what epistemically favorable conditions are.
A lot more could be said along these lines, but here I just want to point out a couple of serious flaws in behavioral economics.
The seminal paper in behavior economics is the 1979 paper simply by Daniel Kahneman and Amos Tversky called “ Prospective client Theory: An Analysis of Decision under Risk. ” This work eventually led to many thousands of citations plus an economics Nobel Prize in 2002. Kahneman and Tversky consulted their own intuitions and came up with simple problems which they then asked person subjects to solve. The final results generally confirmed their intuitions.
Here is a common problem. Subjects were requested to pick one of two choices. In a single case, the choices were A, 4, 000 (Israeli currency) with probability 0. 2, or, B, 3, 000 with probability 0. 25. Sixty-five % of the subjects picked The, with an expected gain 1 associated with 800 over B, selected by 35 percent, by having an expected gain of 750. This represents rational choice on the part of sixty-five percent of choosers.
The authors contrast this result having an apparently similar problem, The, 4, 000, p = 0. 8, versus B, 3, 000, p = 1 . 0. In this case, 80 percent of subjects chose B, the particular certain option with the cheaper expected value (3, 000 versus 3, 200), an irrational choice. Kahneman and Tversky then used this contrast, and the results of many similar problems, to come up with an alternative to regular utility theory.
Prospect concept , as they called it, is not like most scientific ideas, namely a modest set of assumptions from which a lot of predictions can be deduced. It is rather list of effects — such as the assurance effect (this case), loss aversion, confirmation bias, and the like (Wikipedia lists more than a hundred “ biases” like this).
Prospective client theory attempted, with only partial success, to account for these discrepancies by suggesting a modified utility function (a more complex version seems in a later paper), yet basically it is a set of labeling, rather than a theory.
There two problems with this superficially attractive approach: teleology and the item of inquiry. First, as to teleology, the use of utility functions: Ludwig von Mises contended that “ teleology presupposes causality, ” and teleological accounts often fail, as they are either silent on the causal processes which, under some conditions, allow people to increase utility or, more commonly, because they assume that the mathematical method for obtaining the maximum, equating marginals, is in fact the one that people use.
Kahneman and Tversky did not (and we still do not) understand the processes by which people reach their decisions. Hence the particular failure of their teleological models and the reduction of “ prospect theory” to a set of labels.
The more serious problem, hinted in by Rizzo’s Kagan estimate, is prospect theory— any theory that attempts to account for the majority choice— cannot apply to the group choice .
Neither the 35 percent who chose rationally in the first case neither the 20 percent that chose irrationally in the second. If the object of inquiry is the psychology of individual human beings, the work is usually incomplete. To finish the job, the experimenters need to find out what it takes to produce the same result for many subjects.
Kahneman and Tversky’s results, and the theory that describes all of them, are a property of categories of people under very limited conditions. They are not, as is occasionally assumed, general properties of human nature . The method is just opinion polling, albeit with a clever group of questions. Yet each impact is presented as an invariant property of human option behavior . Because the group effect is definitely reliable, individual exceptions are usually ignored.
There is little doubt, for example , that subjects given a lesson or two within probability, or faced with a question phrased slightly differently (e. g., not “ What is your choice? ” but “ What would a statistician choose? ” ), might choose differently. As Rizzo hints at one point, under some conditions, a group might even choose differently than a person.
One example is suppose the subjects had been allowed to consult among themselves before choosing. If the selection were between, say, one, 000 for sure versus a 0. 6 chance of two, 000, would it not be sensible for the group of, say, 20 subjects to agree among themselves to always select the 0. 6 and two, 000 option and then split the proceeds evenly— therefore ensuring that everyone would probably have more than $1000?
People’s choice in a issue like this almost certainly depends on the absolute quantities involved. Who can doubt that if subjects were provided a credible choice among, say $10 million for certain versus a 0. six chance of $20 million, close to 100 percent would choose the sure thing? Until the theory is usually developed to account for the particular minority choice and the a result of absolute amount, until it is in a form that allows simply no individual exceptions, it can not pretend to be an adequate model of human choice behavior.
Hence, very apart from all the other objections to “ nudge” policy is the fact that to the extent that it relies on behavioral economics, it relies upon a fallacy.