Research note. Behavioral Economics and Policy Evaluation

Research note by Tim Brennan on Behavioral Economics and Policy Evaluation

Behavioral economics, roughly defined as the study of behavior in economic contexts when people do not appear to act rationally or in their own self-interest because of cognitive limitations or biases, is playing an increasingly significant role in public policy design. This has been particularly true regarding energy and water use, and regulations in the name of consumer protection. A well-known McKinsey Group analysis of the cost of reducing carbon emissions has found that many ways to reduce those emissions have “negative costs,” that is, they would be beneficial without taking external carbon benefits into account. This leaves open the question of why beneficial opportunities are not already exploited, suggesting the possibility of consumer error.

Behavioral economics, grounded in potential for consumer error, threatens the foundations of benefit-cost analysis (BCA). In practice, BCA relies on the premise that customer choices accurate represent customer benefits. Empirically measured demand and supply curves form the data that policy evaluators use to determine whether benefits exceed cost.  Behavioral economics rejects that foundational premise.

To express this with slightly more detail, BCA’s appeal as a policy evaluation method rests on a series of advantages. It connects available measure to benefits and costs, using decentralized measures using consumer valuations rather than policy-maker preferences. Because winners can compensate the losers, BCA justifies otherwise problematic interpersonal comparisons by adding up net benefits over all those a policy affects, allowing at least in principle a policy that, with redistribution, could benefit everyone. Behavioral economics threatens all of these. Consumer error disconnects actual benefit from measured benefit, with multiple answers depending on which biases one believes applies. Because individual valuation data are suspect, policy makers can invite themselves to substitute their judgment on benefits and costs from those the public has made. No internally consistent method, grounded in individual preference, remains for modifying a policy so winners compensate losers so that everyone benefits.

Cass Sunstein, a leading proponent of both behavioral economics and benefit-cost analysis, does not solve that problem. He has defended BCA because people are as biased and irrational in the voting booth as in the marketplace, which justifies replacing their decisions with those of a government technocrat. How that BCA should be conducted remains open. Douglas Bernheim and Antonio Rangel’s formal models of welfare under behavioral economic assumptions fail to narrow adequately the range of solution. Robert Sudgen acknowledges the potential for cognitive shortcomings, but argues that the market should still be a guide for the most efficient way to deal with them,

If behavioral economics is sufficiently compelling to render supply and demand useless as indicators of marginal cost and willingness to pay, the best alternative may be to use democratic institutions to choose those public officials on the basis of how they would paternalistically substitute their judgment for those of the voters. We rely on democratic delegation to have public officials make policy choices on ethical grounds outside the realm of economics, so it may not be much of a stretch to include economic policy evaluation within this approach. However, this delegation continues to beg the question of how to determine the optimal policy absent reliable individually-based data. We should be sure that the consumer error is substantial before rejecting all of the advantages that benefit-cost analysis provides.


TimBrennanTim Brennan is a professor in the School of Public Policy at the University of Maryland, Baltimore County and a senior fellow with Resources for the Future, in Washington, DC.  He has co-authored two books on electricity markets and co-edited three books on the economics of postal delivery.  He has published over 125 articles and book chapters on competition policy, regulatory economics, energy, telecommunications, intellectual property, and the philosophy of economics.  He has served as chief economist at the U.S. Federal Communications Commission and senior staff economics for regulation with the White House Council of Economic Advisers.  In 2006, he held the T.D. MacDonald Chair in Industrial Economics at that Canadian Competition Bureau.  He holds a Ph.D. in economics from the University of Wisconsin, Madison.