Econ 522 – Lecture 24 (Dec 9 2008)
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
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These are strong assumptions
They are 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.
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
o 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
o someone would pick a prediction of the standard model – for instance,
expected-utility-maximizing under uncertainty, or discounting future
payoffs by a consistent per-period discount rate, or maximizing only one’s
own payoff in a multi-player setting
o 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
about systematic ways in which peoples’ behavior differs from the standard
model of perfect rationality.
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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
o 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.
The paper on the syllabus by Jolls, Sunstein, and Thaler, “A Behavioral Approach to Law
and Economics,” 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.
How people actually behave, and how this differs from the standard model, has
implications for every use of law and economics:
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The positive part
o “Positive” sometimes means “descriptive”, but here it means “predictive”
– making predictions about how people will respond to particular laws
o 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)
o (Positive statements are things like, “an increase in expected punishment
will lead to a decrease in crime”)
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The prescriptive part
o 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
o (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”)
o If people behave differently than the standard model, than the law should
be designed to take this into account
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The normative part
o The normative question is, what should the goal of the legal system be?
o 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
o This gets much trickier when a behavioral approach is used
o One of the observations of behavioral economics is that peoples’
preferences are not as well-defined and stable as the standard model
assumes
o 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.
o 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.
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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:
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Bounded rationality
o People aren’t perfect – we have limited computational abilities, have
flawed memory, imperfect powers of perception
o This leads us to make “mistakes”
o It also leads us to use simple “rules of thumb”, rather than detailed
analysis, in many situations
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Bounded willpower
o Even when we know what’s “right”, we don’t always do it – we eat too
much, don’t go to the gym, have trouble quitting smoking
o This means that commitment devices – finding a way to “give up” options
– can have value, which doesn’t make sense in the standard model
o 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.”
o (This is why savings plans that “force” people to save, or gym
memberships that reward you for going to the gym, can have value)
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Bounded self-interest
o People aren’t completely selfish – we all do nice things for other people.
o 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.
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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
o 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 this case, being given a mug made you value a mug more highly
The next question: so what?
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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.
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.
o This may partly be due to the fact that people adapt to new circumstances
better than they anticipate
o 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
o Again, though, this calls into question which measure should be used in
assessing efficiency
o Suppose someone with two arms thinks losing one would be a catastrophe,
on the order of a $10,000,000 loss
o Someone who lost an arm realizes that life’s still not that bad, and that the
damage done was, say, $500,000
o 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 (choosing between an expensive camera, a
cheap camera, and nothing may make the cheap camera more attractive than if you were
just choosing between the cheap camera and nothing), and the second-cheapest wine
effect (see http://www.mentalfloss.com/blogs/archives/18811 for example).
Another bias Jolls/Sunstein/Thaler discuss is hindsight bias
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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.
o (Ask a Tennessee Titans fan what they thought the odds were in August
that the Titans would have the best record in the NFL
o Once something happens, we can always find ways to rationalize it, even
if it was very unlikely initially.)
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.
o The same thing happens in lawsuits against publicly-owned companies
who failed to disclose a particular risk to investors
o Was the risk material, so the company was fraudulent in hiding it?
o 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.
o One thing they suggest is in some cases, to keep the jury in the dark about
what happened
o Obviously, since they were asked to serve on a jury, the jury knows
something bad happened
o 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
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o 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
o 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
o 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 6070% 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?
 That pre-trial settlements may not happen as often as the standard model would
predict
 And that sharing information won’t necessarily solve the problem
 That is, even if both sides have access to all the same information, they may still
be relatively optimistic about their chances at trial, and therefore unable to reach a
settlement
 (It also has implications for wage negotiations and strikes.)
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(Another example of self-serving bias is the old cliché that 80% of people think
they’re above-average drivers. The authors mention that this sort of bias can be
helpful in designing public campaigns that are more effective. In promoting safe
driving, the move from “drive carefully or you’ll cause an accident” to “drive
carefully, there are bad drivers out there you have to avoid!”)
There’s another bias, similar to hindsight bias, in how people perceive the probabilities of
events.
People tend to overestimate the probability of a certain type of accident happening in the
future if they’ve recently observed a similar accident.
Jolls/Sunstein/Thaler refer to this as availability – a memory of a recent accident is
available in your mind, and colors your perception
Adding to this is salience – basically, how vivid the memory is.
So if you recently passed a car accident while driving, you tend to overestimate the
likelihood of car accidents. If you just saw a news item about lead in toys, or asbestos in
ceilings, you overestimate that risk.
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Jolls/Sunstein/Thaler use this to explain environmental and safety regulations
covering whatever that year’s “hot topic” is, without regard for thoughtful costbenefit analysis
(Recall that we say the “cost per life saved” of safety regulations varying from
$200,000 to over a hundred million or even billions of dollars.)
The problem of perception is made worse, they point out, by the fact that some
people – politicians, or regulators, or concerned citizens who are worried about a
problem – may deliberately try to keep the accident available, in order to gain
from it
They use the term “availability entrepreneurs” for people who try to whip
everyone into a panic about a particular risk, presumably for private gain.
(Think of most politicians in this country after 9/11.)
They use Superfund – the EPA project for dealing with abandoned toxic waste
dumps, passed after the Love Canal scare despite the actual risk being very small.
But a recent example was available, and very salient, so there was no opposition)
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Another example of bounded rationality, which may explain bounded willpower,
is how people discount the future
Peoples’ choices (both in the “real world” and in experiments) do reflect
discounting of future events
But the way they discount them is different from the theory
The dropoff between “now” and “later” is much more severe than the dropoff
between “some future time” and “some later future time”
That is, the difference in value between something happening now versus a year
from now is much greater than the difference between something happening in
five years versus ten years.
One implication is something we’ve already seen: that the last few years of a
prison sentence offer much less deterrence than the first year
Studies with criminals found that a five-year prison term was viewed as only
being about twice as severe as a one-year term – the first year mattered far more,
since it starts now.
The final bias they talk about is bounded self-interest.
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A standard example of this is the ultimatum game
Player 1 is given the opportunity to propose a way to divide up $10 between
himself and player 2
They player 2 says yes or no
If he says yes, they each get their share; if he says no, they both get nothing.
If player 2 is fully rational, he should say yes to any share of the money – even a
penny is better than nothing
 Experiments find that people reject small offers – offers of less than a third of the
total are often rejected
 This, and other evidence, brings Jolls/Sunstein/Thaler to the following
conclusions, which are shocking to economists and completely obvious to
everyone else:
o people are willing to sacrifice their own material well-being to help those
who are being kind
o people are willing to sacrifice their own material well-being to punish
those who are being unkind
(The same observations occur in experimental Prisoner’s Dilemma-type games, and in
lots of other settings.)
One interpretation is that people care not only about their outcome, but on whether it’s
fair. However, “fairness” is not defined objectively – that is, people don’t reject every
offer below 50%.
They say that this preference for fairness may help explain lots of rules we see
empirically:
 rules against scalping tickets in many states
 rules against predatory pricing during emergencies
 rules against usury (unreasonably high interest rates)
Standard economics would suggest these rules are inefficient – any voluntary transaction
should be Pareto-improving, and these rules prohibit such transactions. However, in each
of these cases, prices appear to be “unfair” relative to an available market benchmark.
We discussed earlier that the law may evolve toward greater efficiency. Another
common model (one that we did not consider) is that the law will evolve to favor certain
wealthy or politically-connected individuals, since they can influence the political
process and impose their own interests on the system. Jolls/Sunstein/Thaler suggest a
third possibility: the law may evolve toward agreeing with peoples’ notion of “fairness”
(either because legislators themselves share this preference, or because they think it will
help them win re-election.)
(This also explains why ticket prices are kept at a level low enough for there to be excess
demand – one New York theater owner explained, “Even though we could sell tickets at
$100, we’d be cutting our own throats because it would be a P.R. disaster for Broadway.”
Similarly, why stores don’t raise prices on popular toys that are likely to sell out during
the Christmas rush.)
(Also: failed personalized pricing program on Amazon; failed weather-sensitive Coke
machines.)
Most of the interesting work in the paper has been on the positive questions – how to
more accurately describe peoples’ behavior. They’re weaker on the prescriptive part –
how to design the law to deal with it – presumably because when behavior is different in
different situations, it’s hard to come up with general rules that always work.
One thing they point out is that how people respond to information depends very much
on how it’s presented.
 They give an example: university staff choosing whether to invest their retirement
money in a safe fund (bonds) or a risky one (stocks)
 Those who were shown a distribution of one-year returns of the stock fund
focused on the volatility, and put most of their money in bonds
 Others were shown a simulated distribution of thirty-year returns, based on the
same data; they focused more on the compounding effect of time, and put most of
their money in stocks.
 The authors’ takeaway seems to be that when the government is putting out
information – either to help people make informed choices, or to encourage or
discourage particular behavior – it should think about how the “framing” matters
 Particularly in the second case – trying to push people to behave in a certain way
– they can control the effect of the message by manipulating how it’s presented.
o We saw earlier the example of safe-driving ads focusing on other drivers
being bad, not you
o They give other examples – particularly graphic warnings about cigarette
dangers, phrasing things as losses instead of gains (“if you fail to do a
breast self-examination, you will have a decreased chance of finding a
tumor at an early stage”) instead of positives, etc
They do a little bit on criminal stuff, but nothing we haven’t already seen.
They wrap up with an argument for “anti-antipaternalism”
 Antipaternalism is the notion that the government shouldn’t tell people to do,
since people know what makes them better off and can do it on their own
 They stop short of actually being pro-paternalism, for several reasons – among
them, any behavioral bias that leads individuals to make mistakes, might also lead
government bureaucrats to make the same mistakes when telling people what to
do
 but they argue that we at least shouldn’t automatically reject paternalism, as it
may have a role in some instances.
If you’re interested, the article is on the syllabus, and cites tons of papers addressing
particular biases in particular instances. The book by Sunstein, “Behavioral Law and
Economics,” is a collection of some of these articles; I have it, if anyone wants a look.