Econ 522 Fall 2009 Lecture 24

Econ 522 – Fall 2009 – Lecture 24

Today’s material is not on the final

Pretty much everything we’ve done this semester has assumed that people are perfectly rational, and respond to incentives according to what they correctly perceive to be their own best-interest.

Property and nuisance law: people can bargain with each other to get entitlements to the owners who value them most
Contract law: parties can negotiate efficient contracts, courts can enforce them correctly
Tort law: people react rationally to incentives; courts can assign liability and damages correctly
Criminal law: even criminals react rationally to incentives, commit crimes when benefit outweighs expected costs

These are strong assumptions

They are very useful assumptions
they gave us a lot of predictions about how laws would affect behavior, and therefore what laws would lead to efficiency
But the question remains whether they’re valid assumptions.

Today’s topic:

How these assumptions sometimes fail in real life
And therefore, why we may want to be skeptical about some of the semester’s conclusions
But you’re still being tested on those conclusions come Sunday
Think of today is a tangential detour off of the main material

In the last decade or two, there’s been huge growth in the field of behavioral economics

Behavioral economics studies how peoples’ actual behavior differs from the predictions of the standard model
We mentioned a couple examples over the course of the semester
for example, we mentioned that people don’t react to probabilistic risks the way expected-utility theory would suggest.

Behavioral economics started out as a fairly ad-hoc discipline

someone would pick a prediction of the standard model
for instance, expected-utility-maximizing under uncertainty
or discounting future payoffs by a constant per-period discount rate
or maximizing only one’s own payoff in a multi-player setting
then they would do experiments
have a bunch of undergraduates play games in a lab
or look for instances in the real world where the prediction was violated.

Over time, behavioral economics has generated some fairly robust conclusions

systematic ways in which peoples’ behavior differs from the standard model of perfect rationality.

What’s important is that the way peoples’ behavior deviates from the standard predictions is not random

If it was, we could explain it simply as random errors
people aren’t necessarily infinitely wise, so they sometimes make mistakes in calculating the right behavior
and these mistakes can go in any direction
Instead, we find that peoples’ behavior seems to have consistent biases
that is, in many situations, deviations from perfect rationality all seem to go in the same direction

At its best, behavioral economics also holds itself to a sort of a “higher standard” than traditional economics

Traditional economics makes assumptions (basically, rationality and optimization), derives predictions, and then asks whether the predictions seem to be right, but doesn’t spend that much time questioning the assumptions themselves
Behavioral economics tries to justify the assumptions as well.

(A couple recent “pop economics” books if you’re interested in behavioral economics in general: “Predictably Irrational,” by Dan Ariely; and “Nudge,” by Richard Thaler.)

“Behavioral Law and Economics”, edited by Cass Sunstein. First chapter is the paper on the syllabus, Jolls, Sunstein, and Thaler, “A Behavioral Approach to Law and Economics.” It discusses some of these biases observed by behavioral economists; and proposes how these more complicated (and therefore more accurate) views of human behavior could be incorporated into law and economics.

Earlier in the semester, we distinguished between positive and normative economics. Jolls, Sunstein, and Thaler discuss three different “uses” for economics (or law and econ); behavioral economics has implications for each of these.

The positive part
“Positive” sometimes means “descriptive”, but here it means “predictive” – making predictions about how people will respond to particular laws
The positive approach also allows us to predict (or explain) the laws that do exist – as outcomes of some process (either the common law “evolving” toward efficiency, as we’ve discussed in class; or as the outcome of a legislative process)
(Positive statements are things like, “an increase in expected punishment will lead to a decrease in crime”)

The prescriptive part
Once we know how people react to a given law, we can make prescriptions about how the law should be designed to achieve particular goals
(Prescriptive statements are things like, “to achieve efficiency, the law should specify injunctive relief when transaction costs are low, and damages when transaction costs are high”)
If people behave differently than the standard model, than the law should be designed to take this into account

The normative part
The normative question is, what should the goal of the legal system be?
Throughout this class, we’ve mostly assumed that the goal of the law is economic efficiency – we gave a number of arguments to defend this
This gets much trickier when a behavioral approach is used
One of the observations of behavioral economics is that peoples’ preferences are not as well-defined and stable as the standard model assumes
But this makes even measuring efficiency hard, since we don’t know what preferences to use
An example: one of the findings of behavioral economics is that people value things more once they have them
So if I gave one of you a chocolate bar, you might get all excited about it, and be more hurt by losing it than if you hadn’t had it to begin with
Suppose I give one of you a chocolate bar, and offer you an opportunity to sell it to someone else
Good chance you wouldn’t
Even if I offered to subsidize the purchase – I’d throw in 50 cents on top of what they pay you – you might not
So we’d conclude you value the chocolate bar more than them.
But if we’d started out giving the chocolate bar to them, maybe they wouldn’t have wanted to sell it to you either.
But this muddles the question of who values it more: if I give it to you, you value it more than him; if I give it to him, he values it more than you. But now we have no way to gauge which allocation is efficient!)

So that’s the goal of behavioral law and economics – to give a more accurate model of how people actually behave, and use that model to reconsider the positive, prescriptive, and normative conclusions of law and economics.

The Jolls, Sunstein and Thaler paper concedes that so far, the results are fairly sparse
the paper reads more like a proposal for future research than a bunch of conclusions
Still, some of the initial results – basically, taking behavioral biases documented elsewhere and considering their implications for law and economics – are quite interesting.

Behavioral biases – the way peoples’ actual behavior deviates from the standard model of perfect self-interested rationality – are generally broken up into three categories:

Bounded rationality
People aren’t perfect – we have limited computational abilities, have flawed memory, imperfect powers of perception
This leads us to make “mistakes”
It also leads us to use simple “rules of thumb”, rather than detailed analysis, in many situations

Bounded willpower
Even when we know what’s “right”, we don’t always do it
we eat too much
we don’t go to the gym often enough
we have trouble quitting smoking
This means that commitment devices – finding a way to “give up” options – can have value, which doesn’t make sense in the standard model
We’ve all seen people turn down leftover cake – “if I have it at home, I’ll eat it, and I don’t want to eat it.”
(This explains savings plans that “force” people to save, or gym memberships that reward you for actually going to the gym)

Bounded self-interest
People aren’t completely selfish – we all do nice things for other people.
But even in anonymous situations with strangers, people tend to care about others’ outcomes as well as their own – we’ll see examples.

On to some examples.

We begin with an experiment done at Cornell.

The experiment took 44 students in an advanced undergrad Law and Econ class, and gave half of them tokens
Each person – both those who got tokens and those who didn’t – was also given a personal value, an amount of money they could exchange a token for at the end of class if they have one
Then people were given an opportunity to trade.
The market for tokens worked just like the standard model would predict
people with higher token values bought them from people with lower token values

But that was with tokens, which had an artificial value that everyone knew objectively
So they reran the experiment
This time, half the class was chosen at random and given Cornell coffee mugs
Then students were allowed to trade.

If, like in the standard model, each person knew exactly what a mug was worth to them, we’d predict about half the mugs would trade hands
Since the people who got them were chosen at random, about half the mugs should have gone to people who valued them above the median valuation, and half to people who valued them below that
that latter half should all have been sold, to the people with high valuations who didn’t get mugs
Instead, only 15% of the mugs traded hands
And on average, people who got mugs asked more than twice as much money for them as the people who didn’t get them were willing to pay
And the effect didn’t go away if the experiment was repeated.

The conclusion was that having something makes you value it more – this is referred to as an endowment effect
In thiscase, being given a mug made you value a mug more highly

The next question: so what?

Well, the big “so what” is that this seems to contradict Coase
Coase predicted that without transaction costs, the initial allocation should not affect the final allocation – whoever starts out with an object (or an entitlement), it will naturally flow to whoever values it the most
But endowment effects mean that the initial allocation does matter, in terms of predicting the final allocation
And if preferences really change depending on whether you got the object, it becomes very unclear how to even define efficiency!

Recall what we said about injunctive relief in nuisance cases
We argued that when transaction costs are small, injunctions would work well, since they clarify the two sides’ threat points so they can bargain to an efficient outcome
Endowment effects challenge this result – they say that whoever is allocated the right initially, comes to value it more, and therefore may not be willing to give it away, regardless of who efficiency would have favored ex ante.

The existence of this bias is fairly robust
One of the chapters in Sunstein’s book, “Behavioral Law and Economics,” documents twelve different studies where peoples’ Willingness to Pay for something they didn’t have was compared to their Willingness to Accept an offer for something they did
In every case, the payment required to give up something they had was greater – typically three times greater or more – than their willingness to pay
(example: willingness to pay to preserve natural resources)

This also has implications for calculating damages
If you asked someone ahead of time how much money they would accept to lose an arm, the number would be huge
If someone lost an arm, and you asked them how much money it would take to make them overall as well-off as before, the number would be smaller.
This may partly be due to the fact that people adapt to new circumstances better than they anticipate
That is, if someone loses their arm, they find ways of dealing with it which make it less bad than they would have guessed ahead of time
Again, though, this calls into question which measure should be used in assessing efficiency
Suppose someone with two arms thinks losing one would be a catastrophe, on the order of a $10,000,000 loss
Someone who lost an arm realizes that life’s still not that bad, and that the damage done was, say, $500,000
Is it efficient for a construction firm to take precautions that cost $3,000,000 to prevent each lost arm?

Another bias in how people evaluate options: context dependence

Basically, how you choose between different options may depend on what else you’re considering
Example: the attractiveness of a “compromise” solution
Suppose you’re deciding whether to buy a basic, $100 digital camera or keep using the one you’ve got
If there’s another option – a fancier camera for $500 – it makes the $100 camera seem like a better deal, and might make you more likely to buy it!
There’s also a well-documented “second-cheapest wine effect”
(see for example)

Another bias Jolls/Sunstein/Thaler discuss is hindsight bias (mentioned earlier)

Once something happens, people have trouble assessing what its likelihood was before the fact
Specifically, they overestimate what the ex-ante probability was, once they know that the thing did in fact happen
Think back to one year before the election, and guess what the odds were at the time that Obama would be elected
Since it happened, it seems very likely
But in November 2007, Intrade had Obama as about 7% likely to win

Why does this matter?
Determining negligence usually requires figuring out what the probability was that something would happen, after it happens
A storage company decides the risk of a fire at its warehouse is 1 in 1000, and so it doesn’t install a $10,000 sprinkler system to protect $1,000,000 in stored goods
Now a fire occurs, and the jury has to sort out whether the company was negligent
Knowing the fire occurred, the jury might decide the probability of a fire was 1 in 50, and find the company liable.
The same thing happens in lawsuits against publicly-owned companies who failed to disclose a particular risk to investors
Was the risk material, so the company was fraudulent in hiding it?
Or was it an extremely small risk that just happened to occur, so the company did its job and got unlucky?

The effect of hindsight bias should be clear: juries will find negligence more often than they would if they could perfectly assess ex-ante probabilities after the fact

The proposals Jolls/Sunstein/Thaler give for dealing with hindsight bias, though, have problems themselves.
One thing they suggest is in some cases, to keep the jury in the dark about what happened
Obviously, since they were asked to serve on a jury, the jury knows something bad happened
However, in some cases, either action or lack of action would entail risk: treating a patient with a risky drug might cause them to die, but not giving them the drug might also cause them to die
They suggest the jury could be given the facts available at the time, without being told what choice was made, and asked to decide if either action would have constituted negligence
Still, this won’t always work, since in many cases the jury will be able to infer what happened from the fact that there’s a trial at all
and in order to make this work, the jury would have to not read newspapers or know anything about the trial, and not even know which lawyers represented the plaintiff and which ones represented the defendant!

The other suggestion they make is to raise the standard of proof for finding negligence – from “preponderance of the evidence,” interpreted as 51% certainty, to, say, the “clear and convincing evidence” standard, generally interpreted as 60-70% certainty

But this assumes that hindsight bias is of a certain magnitude, not just that it exists; and that the “preponderance of the evidence” standard would be efficient if there were no hindsight bias.

Another bias they consider is what they call “self-serving bias”.

This can be thought of as relative optimism that exists even when both sides have the same information.

In another experiment they cite, students – undergrads and law students – were randomly assigned to the roles of plaintiff and defendant, knowing they would be asked to negotiate a settlement

They were all given the same facts – based on an actual case in Texas

Prior to negotiations, they were each asked to write down a guess as to the damages the judge actually awarded, as well as what they felt was a “fair” settlement – these answers would not be used in any way during the negotiations.

Although they were chosen randomly, the students chosen to represent the plaintiffs guessed $14,500 higher than those representing the defendants as to the judge’s actual award, and answered $17,700 higher when asked for a “fair” settlement.

(They give another example where the presidents of teachers unions and the presidents of school boards were asked what other cities were “comparable” to their own, since comparables were often brought up during salary negotiations. Not surprisingly, the union presidents listed cities with higher average salaries than those listed by school board presidents.)

What does self-serving bias suggest?