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Behavioral economics: New trick for government financing? Part 1

Finance Blogger: Anthony Harrington Anthony Harrington

Anyone who studies markets, particularly anyone who trades, knows that human psychology plays a huge role in seemingly random market movements. The same line of thinking opens up the possibility that there might be smarter and more cost-effective ways for governments to interact with the general public on a whole range of issues. The obvious example of “behavioral economics,” often cited in the literature, is the different outcomes you get when people are auto-enrolled into workplace pension schemes, versus having the option to opt-in to those schemes. Many more people end up saving in pension schemes with auto-enrolment.

Why? Clearly inertia plays a huge role in human behavior, meaning we are substantially more likely to continue sitting on our behinds than we are to get up and act, which is probably why the good Lord put a decent selection of carnivores into the world, to ensure that our ancient forebears stayed nimble and on their toes.

Alas, the saber-toothed tiger is now long gone and we must make do as a species with behavioral economists, it seems, to nudge us along. However, keeping the debate at the effort-versus-inertia level would not produce a very rich inspirational source for government policy, so bringing economics into the frame looks promising. One of the foremost theorists on this emerging intersection between government policy and behavioral economics is Cass Sunstein, a US law professor with an interest in the overlap between law, policy, and economics. He co-authored a book, Nudge: Improving Decisions about Health, Wealth and Happiness, with the economist Richard Thaler, and heads up the Obama Administration’s Office of Information and Regulatory Affairs.

In a recent paper, “Empirically informed regulation,” Sunstein draws on work designed to incorporate empirical findings about human behavior into economic models, in order to suggest how regulation could be designed to be lower cost and more effective. Lawmakers can achieve this by going with the grain of predicable behavior, rather than against it, so to speak. A general lesson, he argues, is that small, inexpensive policy initiatives can have large and highly beneficial effects.

For instance, the more complex the choice you lay before people, and the more perceived barriers they have to work through to enable that choice, the less likely you are to get them to move through that particular gate. “Complexity can have serious adverse effects by increasing the power of inertia,” Sunstein writes. Simplifying choices and removing the amount of paperwork that people have to fill in, makes them much more likely to act. Obviously, if you are highly motivated to buy a house, you will battle through the mortgage application form, come what may, but if the form was simpler, the dropout rate would be lower. The same is true of loan applications and so on and so forth.

Actually, of course, the British Civil Service has known about and exploited the power of inertia for decades, possibly centuries. When ministers come up with a plan of which the Civil Service disapproves, they smother it in paper. Sunstein wants to go in the other direction, and one has to grant that, in the context of government bureaucracy, this kind of thinking is, if not novel (people have, after all, been banging on about cutting red tape for a very long time) at least helpful.

One of the main factors that Sunstein wants to take into account is the fact that people in fact tend not to behave like the ideal “rational citizen” upon which the rational model is predicated. People procrastinate and neglect to take steps that impose small, short-term costs but that promise large, long-term gains. They delay starting to exercise until they are so overweight they couldn’t start if they wanted to, or they delay seeing a doctor about a nagging cough until their lungs are beyond salvation with lung cancer. Many still smoke!

So what can government do? Government programs and funding should be channeled not just to informing people what they should do, but also towards designing programs that make it easy for people to act on the choices government wants them to make. The more specific and focused the message, the better. As he puts it:

“In many domains, the identification of a specific, clear, unambiguous path or plan has an important effect on social outcomes. Complexity or vagueness can ensure inaction, even when people are informed about risks and potential improvements. What appears to be scepticism or recalcitrance may actually be a product of ambiguity.”

The idea has caught on to the point where the UK Government now has a specific policy-making unit focused on behavioral economy and its implications for government policy. More of that in Part 2.

Further reading on economics and government financing

Tags: behavioral economics , government funding , inertia , psychology
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