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GHEI: Setting the ‘nudge squad’ on unruly consumers

A free market provides better choices than behavioral regulators

- - Friday, August 16, 2013

The White House is in the initial stages of setting up what is already being dubbed a "nudge squad" with the goal of borrowing insights from behavioral economics to get people to make better choices.

The alphabet soup of agencies to which Congress has delegated vast power has already been experimenting with regulations aimed at correcting "irrational" consumer choice rather than confining itself to a more traditional role of correcting market failures. The result has been rules that limit choice and increase costs, particularly for the most vulnerable consumers. Constraining consumer choice is not a solution; it's the part of the problem.

With the rise of behavioral economics, there is now a substantial body of evidence that individuals do not always act rationally. Nonetheless, an equally substantial body of evidence from experimental economics, led by Nobel laureate Vernon Smith, demonstrates that even though individuals make errors, markets can and do very often achieve efficient results. The need for regulation, therefore, is questionable. In fact, these regulations often disproportionately burden low-income households. Any regulation based on "debiasing" or correcting"irrationality" should be subject to stringent scrutiny prior to implementation.

One of the more obvious ways in which people act irrationally is by exhibiting a lack of self-control: when they overeat, when they gamble and when they engage in abuse substance. Another form of error arises when people resist making changes, even when presented with evidence of what is arguably a superior alternative. There is, then, an argument for policy to correct these "irrational" errors, and regulation expands beyond its traditional scope of correcting market failure.

Federal agencies have been experimenting with such regulations for a while. The Food and Drug Administration has regulations that seek to correct "irrational" choices that lead to obesity, but they have been largely ineffective. The corporate average fuel economy (CAFE) standards, which involves the Department of Transportation and the Environmental Protection Agency in consultation with the Department of Energy, is based on a cost-benefit analysis that only regards fuel efficiency as a benefit to consumers and discounts cost factors. When a consumer is shopping for a vehicle, though, he will weigh many concerns, including safety, reliability, the number of passengers to be transported and freight space, in addition to fuel efficiency. A family with several children might well value space over fuel efficiency, while someone with a short but difficult urban commute might put a premium on reliability. Regulations like the CAFE standard, in which 87 percent of the alleged benefits derived from correcting consumers' gas-guzzling "irrationality," force Americans to pay for fuel-saving features they don't want.

Even more serious are poorly thought-out restrictions, like those on overdraft lending and payday lending. While seemingly protecting consumers from "irrational" and expensive transaction fees, such rules interfere with consumer choices that for some, are the lowest-cost options available. For a consumer with less-than-perfect credit, overdraft protection might well be cheaper than riskier alternatives, such as pawn brokers. As George Mason School of Law professor Todd Zywicki has demonstrated, restrictions on overdrafts actually raised costs for lower-income households.

There is little evidence that these regulations — from fuel- and energy-efficiency standards that limit the choices of which vehicles we drive, to regulations that aim to nudge our food choices, to restrictions on overdraft protection — benefit consumers. On the contrary, by limiting choices, such rules make many of us worse off, and the poorer among us are least able to absorb the additional cost. In many cases, the market provides solutions. In the case of obesity, gyms and yoga studios can be just as effective as food regulations that can stifle innovation.

Regulators, after all, are human and, therefore, subject to the same biases and irrational errors as everyone else. Supreme Court Justice Stephen G. Breyer has pointed out that regulators are particularly vulnerable to "tunnel vision," where they lose sight of the larger picture as they focus on low-probability risks.

Government should not be in the business of making or shaping choices for adults. Regulations should preserve choices. Limiting options should never be counted as a benefit in the strict benefit-cost analysis that is part of any rule-making initiative. Nudges and shoves hurt — and the poor suffer the most.

Nita Ghei is policy research editor at the Mercatus Center at George Mason University.