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Economics after behavioral attack

Behavioral issues in energy and the environment

Economics 331bSpring 2011

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Agenda as of 2/16Today: Behavioral economics

Friday: Lint will lead review session

Monday: Climate science

Wednesday: Climate science and IAM

Thursday: review material in sections

Friday: midterm in class

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Background

Major grounds for government intervention in energy and environmental markets:

1. Market failures (uninternalized externalities such as CO2 emissions, oil premium, …)

2. Behavioral failures (informational, decisional, etc.)

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A central behavioral puzzle:First-cost v. deferred cost

The energy efficiency puzzle:Consider the life-cycle cost (LCC) of an automobile:LCC = Purchase price + ∑(1+r)-t FutureCostt

= First cost + Deferred cost

Finding: Deferred cost is generally discounted by 50% or more.

What is going on here?

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The challenge to mainstream economics

Here are some issues of decision theory from standard economics that are challenged (from least to most damaging):1. People have good information and/or process information

efficiently (data competence)2. People act to optimize their preferences relative to

information and resources (decision competence)3. Institutions are appropriately designed so that people

acting rationally will make good decisions (good institutions).

4. People have self-interested and stable preferences over consumption of goods, services, and capital (non-weird preferences)

Behavioral economics challenges all of these.

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1. Informational incompetenceClassical view: People have good information and/or process

information efficiently

Behavioral view: People have all kinds of biases in structuring information (law of small numbers, overconfidence, anchoring, hindness bias)

Examples of overconfidence effect: • Second-year MBA students overestimated the number of

job offers they would receive and their starting salary.• Students overestimated the scores they would achieve on

exams.• Almost all newlyweds in a US study expected their

marriage to last a lifetime, even while aware of the divorce statistics.

• Most smokers believe they are less at risk of developing smoking-related diseases than others who smoke. 7

What did people do in buying a car relative to a survey?

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2. Decision incompetence

Classical view: People act to optimize their preferences relative to information and resources

Behavioral view: People make all kinds of trivial and tragic mistakes in daily life

Examples: • Bet on red because red “is due to come up soon.”• 4 million unwanted pregnancies a year• 37,000 traffic fatalities in 2008• Addictions (smoking, alcohol, …)• Default option matters in pension decisions, organ

transplants• Refusal to lower the asking price on house because it is

below the price you paid for your house?• MPG illusion

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Defaults matter for organ transplants

Eric J. Johnson and Daniel Goldstein, “Do Defaults Save Lives?” Science, Nov 2003. 10

3. Bad incentives and institutionsClassical: Institutions are structured so that rational actors will

produce efficient decisionsBehavioral: All kinds of principal-agent problems get in the

wayExamples:

– Energy pricing: Yale pays the electricity bill, so the price of higher energy use to students and faculty is…. ZERO.

– Tax distortions– Political: what are the incentives for political leaders to

set MSB=MSC?

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Zero marginal cost energy

Effect of energy incentives on energy in rent v. own

13International Energy Agency, Ming the Gap, 2007

4. Weird* preferencesClassical: People have self-interested preferences over

consumption of goods, services, and capital (standard preferences)

Behavioral: People are altruistic, care about fairness, will contribute to the public good, have spite.

Examples: • Prisoners’ dilemma: In fact, people are much more

likely to cooperate than the PD game would predict. (Good news for public goods)

• Spite: But some people will fight to the death and bring everyone else down with them (Hitler)

In sense of not conforming to classical economics. Not purely concerned with optimizing a stable, time-

consistent, purely self-interested, complete set of preferences over all market and non-market goods and services for all periods in the future.

Also, altruistic, kinky, funky, wild, erratic, spaced-out, random, slapdash.

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Weird preferences (cont.)Classical: People have well-defined and stable preferences

over goods and time (stable preferences)Behavioral: People have status-quo bias, reference levels,

adaption, loss aversion, hyperbolic discounting, uncontrollable passion or rage

Examples: – Hyperbolic preferences: overdiscount future pains and

benefits– Difference between willingness to pay and willingness

to accept in contingent valuation studies (for say species extinction)

– More important is adaptation to current situation: happiness paradox, lottery winners, quadriplegics, “rat race” or “treadmill” syndrome

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What are policy responsesFor first three, not deep philosophical issues and

requires education, better information, nudges:

• Data incompetence: provide better data or simplify calculations (labeling, $ labeling on energy using appliances)

• Decision incompetence: “Nudge” to more sensible decisions with different default options (“soft parentalism”).

• Bad institutions need fixing (meter Yale rooms?)

For last one, deep philosophical and political issue about whether should respect individual preferences:

• Preferences: – “Weird” preferences: Shouldn’t we respect them?– Incoherent preferences: Should governments override them?

Treat people like children? 16

What should we think about?• The gasoline paradox: People pay $0.37 for $1 of

PV of gasoline savings?• The organ transplant opt-in/opt-out paradox.

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First-cost v. future costThe energy efficiency puzzle:Consider the life-cycle cost (LCC) of an automobile:LCC = purchase price + present value running costs

= purchase price + ∑(1+r)-t FutureCostt

Basic result is that the breakeven discount rate is 20+% p.y [E.g., Allcott and Wozny ≈ 60 % per year]

What is going on here?• Incomplete information about MPG or fuel prices?• Risk or loss aversion?• High discount rates and hyperbolic discounting?• Principal-agent conflicts?• Computational incompetence (bounded rationality)?• Limited managerial time?

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Defaults matter for organ transplants

Eric J. Johnson and Daniel Goldstein, “Do Defaults Save Lives?” Science, Nov 2003. 19

The Zillion Dollar Question

Are all these minor “anomalies” … or are they central to economic behavior?

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