The New Market Failure

by Russ Roberts on September 14, 2006

in Regulation

John Cassidy writes about neuroeconomics in the New Yorker and finds a new market failure:

Today, most economists agree that, left alone, people will act in their own best interest, and that the market will coördinate their actions to produce outcomes beneficial to all.

Neuroeconomics potentially challenges both parts of this argument. If emotional responses often trump reason,there can be no presumption that people act in their own best interest. And if markets reflect the decisions that people make when their limbic structures are particularly active, there is little reason to suppose that market outcomes can’t be improved upon.

The limbic structure is the part of the brain that is active when people are angry or feeling distress or generally when they feel emotion, in contrast to the "rational" part of the brain. So the research suggests people may not be acting in their own self-interest as economists usually define it.

Cassidy goes on to talk about savings—people have trouble avoiding the temptation to consume now rather than save—and whether there are ways for people to pre-commit to savings in order to avoid temptation:

Laibson and Brigitte Madrian, an economist at the Wharton School, have studied one such “pre-commitment device” for 401(k) plans, which deduct part of an employee’s earnings each month and invest them in stocks and bonds. Because the plans are often optional, many people fail to join them, even when their employers offer to match a portion of their contributions. Laibson and his colleagues have called for people to be automatically included in the plans unless they choose to opt out. At companies that have adopted such a policy, enrollment rates have increased sharply.

Reforming 401(k) plans is an example of “asymmetric paternalism,” a new political philosophy based on the idea of saving people from the vagaries of their limbic regions. Warning labels on tobacco and potentially harmful foods are similarly intended to keep subcortical structures in check. Neuroeconomists have suggested additional policies, including warning buyers of lottery tickets that their chances of winning are practically nonexistent and imposing mandatory “cooling off ” periods before people make big-ticket purchases, such as cars and boats. “Asymmetric paternalism helps those whose rationality is bounded from making a costly mistake and harms more rational folks very little,” Camerer, Loewenstein, and three colleagues wrote in a 2003 issue of the University of Pennsylvania Law Review. “Such policies should appeal to everyone across the political spectrum.”

I guess I’m not part of the political specturm. Asymmetric paternalism has no appeal to me whatsoever. My next EconTalk conversation will be this Monday with Ed Glaeser—we discuss the dangers of soft paternalism, this kind of so-called gentle urging by the government (warning labels, mandatory opt-out provisions) to "improve" our decision-making.

Glaeser and I share one important belief derived from neuroeconomics: politicians have a limbic region of the brain just as you and I do. Here’s a nice article summarizing Glaeser’s objections to the new paternalism.


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