Why we sometimes choose wrongly

When a child chooses chocolate ice-cream over vanilla, she is revealing her preferences and there is nothing to do but accept it. But what about when she spends time watching television rather than studying? What about those who choose the default option (on pension, savings account, insurance) regardless of what the default is? And those 70% of smokers who would like to quit smoking but don’t or can’t? In a recent NBER working paper, Beshers, Choi, Laibson and Madrian summarise the five main factors that can create a disparity between the choices that people make and the ones that are actually in their interest: passive choice, complexity of options, limited personal experience, third-party marketing, and intertemporal choice.

1. Passive Choice

In many situations, economic agents do not actively make choices. Instead, they passively accept defaults that are chosen by others…For instance, an agent may accept a default she knows is not optimal because she plans to switch to a superior alternative soon. However, if the agent procrastinates, this switch will not materialize or will be delayed.

2. Complexity

Problems that are hard to solve tend to delay choice because they force agents to incur large up-front problem-solving costs. Thus, complexity increases the fraction of individuals that accept default options…Complexity also biases choice, since people tend to avoid more complicated alternatives.

[For example],the large number of available investment options makes asset allocation decisions complex. For instance, at year-end 2005, there were 8,454 mutual funds registered in the United States. Allocating money across these mutual funds is an overwhelming task… A superabundance of options delays savings plan enrollment.

[Another example:] A typical employer-sponsored savings plan allows employees select any contribution rate up to 15 or 20 percent of their pay. Iyengar, Huberman and Jiang (2004) document a negative relationship between the number of investment options offered in a savings plan and employee participation: each additional 10 funds in the menu of investment options is associated with a decline in participation rates of 1.5 to 2.0 percentage points.

3. Limited Personal Experience

A child learns that hot food burns the roof of his mouth through experience rather than lectures. Likewise, video renters learn to return their videos on time after paying a late fee…Consumers with little or no feedback are not likely to learn what is in their best interest. What personal experiences could teach a middle-aged worker whether she is saving the right amount for retirement?

In principle, she could learn by observing others, particularly people in older generations…[But], people are generally far more responsive to their own experiences than the experiences of others. For example, Choi, Laibson, and Madrian (2005a) show that when Enron, WorldCom, and Global Crossing employees’ 401(k) balances—which were heavily invested in their employer’s stock—were wiped out by those companies’ bankruptcies, workers at other U.S. firms did little to reduce their own investments in employer stock.

4. Third-party marketing

It is not obvious how economists should evaluate preferences for branded commodities. If people feel good when they drink Coke out of a Coke bottle, it might not be problematic that they buy Coke even though they prefer the taste of Pepsi in double-blind tastes. However, there are some cases where such brand preferences may not deserve normative weight. When asset management firms induce their clients to invest in dominated (high-fee) assets and when employers persuade their rank-and-file workers to hold employer stock, economists should wonder whether these revealed preferences have normative legitimacy or reflect mistakes.

5. Intertemporal choice (from Chabris, Laibson and Schuldt)

Most choices require decision-makers to trade-off costs and benefits at different points in time. Decisions with consequences in multiple time periods are referred to as intertemporal choices. Decisions about savings, work effort, education, nutrition, exercise, and health care are all intertemporal choices.

Individuals typically discount delayed rewards much more than can be explained by mortality effects… Higher discount rates are empirically associated with a variety of substance abuse and impulsive conditions, including smoking, alcoholism, cocaine and heroin use, gambling, and risky health behaviours. By contrast, low discount rates may be associated with high cognitive ability.

The fact that people make mistakes leads to the obvious debate about what governments ought to do:

Authors like Hayek (1944) and Friedman (1962) have convincingly argued that governments are not likely to successfully divine people’s preferences and make optimal choices on their behalf. We agree. If we had to choose between government paternalism or consumer autonomy, we would take the latter without hesitation. Like most economists, we worry about the overconfidence, arrogance, and corruption of powerful political decision-makers.

In practice, however, we do not need to choose between the extremes of paternalism and autonomy. For example, consider the role of the medical doctor (or the car mechanic). Doctors are experts who advise their patients on decisions (and even make some decisions for their patients). On the other hand, the doctor’s authority is only delegated authority. The patient or the patient’s family is free to ignore the doctor’s advice. The doctor plays an advisory role to an autonomous consumer.

Like doctors, the government (and other influential social institutions, like employers) are in a good position to advise autonomous agents without dictating to those agents. We believe that such advisory roles are appropriate, though they need to be monitored to reduce the likelihood of abuse. Governments could play a constructive advisory role if (1) their advice is only given in circumstances when the many different measures of normative preferences discussed above tend to coincide, and (2) their advice is offered  without any obligation to obey (e.g. an opt-out default). By contrast, in cases with ambiguous or contradictory measures of normative preference, we side with Hayek and Friedman – government should withdraw.