Libertarian Paternalism: a Prospect Theory Follow-Up

“What makes the bias particularly pernicious is that we all recognize this bias in others but not in ourselves.”

Richard Thaler


In my previous article I alluded to a seemingly oxymoronic concept: Libertarian Paternalism. It was noted in relation to the work of Danny Kahneman and Amos Tversky, and the notion of consumer irrationality; a concept that influenced the trajectory of modern economic study considerably. Their work inspired the likes of Richard Thaler and Cass Sunstein, who would go on to join the search for new economic wisdom. Thaler would wind up winning the Nobel Prize for Economics*, and the respect of the crustiest of classical economists. Thaler and Sunstein would collaborate on the practical application of this newfound knowledge, co-authoring numerous papers and playing instrumental roles in the creation of the UK Behavioural Insights Team. Their most relevant work to the topic of Libertarian Paternalism is the paper Libertarian Paternalism, surprisingly.

The paper underlines the role of irrationality in the need for intervention. Welfare is very rarely maximised when left to the preferences of consumers, and so the need for intervention is dire; greater public welfare, a lower taxpayer burden in caring for the elderly, and an overall reduction in negative externalities are just a few broad examples of how interventions can benefit the economy and society in general. The overarching idea of Libertarian Paternalism is to manipulate transaction costs in the selection of different options, encouraging consumers to make certain, more welfare-yielding choices whilst ensuring that access to other, more detrimental options is not restricted (as a means of appeasing libertarians). In doing so, the consumption of ‘merit goods’ theoretically rises, and ‘demerit goods’ are kicked to the curb. This is all done within a framework that ensures liberty, whilst passively manipulating the choices that consumers make. And, from a consumer’s point of view, when we are in the thralls of such manipulation, we rarely notice it. When was the last time you realised in the canteen that the fruit were positioned more conveniently than the bars of chocolate? Ploys like this use the tool of ‘framing’, i.e. changing the way options are presented in a way that alters transaction costs, incentivising your lazy system 1 (see Thinking, Fast and Slow by Danny Kahneman) to choose the more convenient option. When you begin to look around, you may notice the subtle attempts to influence our behaviour; these are the legacy of individuals like Kahneman, Tversky, Thaler, and Sunstein.

Thaler and Sunstein also refer to work by Bernartzi and Thaler on pension plans. They realised that many savings plans were opt-in, which posed a considerable transaction cost to many individuals. Their hypothesis was something like this: if we can reduce the transaction cost of having a savings plan, are we likely to see a rise in the proportion of working individuals saving, and saving more in correspondence to pay rises? They set about testing their hypothesis, and landed on the ‘Save More Tomorrow’ pension plan. This was a plan that automatically enrolled workers, and meant no opt-in was required. Furthermore, when the individuals enrolled were given pay rises, their savings rate would automatically adjust to reflect a higher level of earnings. The savings rate of workers rose, within 3 years, from 3.5% to 11.6%. The pension plan experiment is important for two reasons, which will both be explained.

Reason 1: Status-Quo Bias

Status-Quo Bias relates to the tendency of policies employed by both the private and public sectors to remain in place for long periods of time. This explains how such pension plan schemes are left untouched, often for extended periods, despite frequent changes in macroeconomic trends and financial instruments available to the average saver; the transaction cost (a running theme here) simply provides too much friction to justify a change in operations. Thaler and Sunstein refer to this as a kind of inertia, whereby the absence of a force of change results in there being a lack of motion. This results in choices being made that perhaps maximised welfare in a time gone by, but not in the present moment. Adjustment to innovation and macro trends is necessary to ensure welfare does not get left in the past; if the government did not mandate the movement to electric cars, it is not hard to imagine that fewer individuals would be so enthusiastic about them. By inducing a change on how pension plans were structured, Bernartzi and Thaler challenged the status-quo, and people liked it.

Reason 2: Intertemporal Choice

Intertemporal choice relates to the way individuals often have a choice of consumption in the present or in the future. It is a straightforward matter when we are offered the same reward, but to be consumed either right now, or in three weeks. Those of us with free time and are prepared for the reception of the reward will choose to consume now; that is the rational choice. Things get more complicated, however, when we have two options: redeem our reward in the present moment, or redeem a greater reward further down the line. What we arrive at is intertemporal choice. When applying a discount to the future reward (the cost of waiting), which becomes the more attractive prospect? This concept has a direct implication for the pension plan. The use of a proportionate raising of the savings rate in response to a pay rise takes the calculation out of the consumer’s hand. As humans, there are limits to our computational ability. It is impossible to calculate the utility and cost of every decision we make, and even more so when the decisions have an implication for our future. We fall back on mental shortcuts, known as heuristics, which are often a breeding ground for irrationality. In the case of the pension plan, the consumer is expected to calculate whether they are better off spending that additional income or saving it. Thaler argues it is far better to save too much for retirement than too little (a view shared solely by economists. the rest of us would rather have that shiny new [insert materialistic object here]). Applying this logic, the use of an automatic rise in the savings contributions takes the decision out of the individual's hand, whilst still allowing them to feel the warm glow associated with having slightly thicker pockets at the end of the month. Heuristic removed, bias avoided.

So, Libertarian Paternalism: who says no? Many economists still vehemently refute any kind of paternalism; in their view it is obstructing absolute free choice, which could lead to market inefficiency and a failure to realise maximal utility. This does, however, urge another question. How to correct market failure that occurs as a result of the underconsumption of merit goods and the overconsumption of demerit goods? Perhaps another topic for another day.

Thaler and Sunstein do however aim to appeal to the crustier, more classical of those whom they are trying to win over. They maintain that underlying principles of free choice remain in place, and those who are perhaps less concerned about the future, more present-moment oriented, or just plain misinformed are still given the opportunity to operate irrationally. After all, as Nietzsche once said, the irrationality of a thing is not an argument against its existence, rather a condition of it.

*The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel is the real name.

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