Monday, 31 March 2014

Pensions and present day bias

In the UK budget a week or so ago the Chancellor surprised most by announcing a radical shake up of the UK pension system. According to the old system retirees, with a private pension plan, were essentially forced to buy an annuity that would smooth income over their remaining life. Under the new system retirees can withdraw the money and spend it as they wish. So, if they want to splash out on a Lamborghini sports car then fine (according to the pensions minister). 
           What has interested me most about the pension changes is the public reaction. Immediately, people began questioning whether it made sense to let retirees have freedom of choice. Are pensioners capable of make informed rational decisions about how to spend their savings? Will they not blow it all and be left to live out their lives on state support? To most people it seemed obvious that some might make dumb, inappropriate choices. And, for me, this illustrates how divorced from reality economic theory has become.
          Thankfully, we now have a theory of why people may make inconsistent choices over time (see, for example, the article 'Doing it now or later' by Ted O'Donoghue and Matthew Rabin). The theory points towards time-inconsistent preferences with a present day bias. The bias basically means we treat today as 'special' relative to the future. And that means we may be unable to stick to long term plans. For instance, on Friday you might plan to clean the garage on Saturday, on Saturday you think 'maybe next week', and on Monday you regret not cleaning the garage. The present bias in this example manifest's itself on Saturday: From the perspective of Friday or Monday, Saturday is just any other day. But, when Saturday is today it's special, and you do not want to clean the garage!
          Everybody is surely familiar with the consequences of time-inconsistency - planning to do something, but then not wanting to do it when the time comes. The idea that pensioners might blow all their pension money unwisely seemed common sense to most. Standard economic models, however, take no account at all of time-inconsistency. And even though we now have simple models of time-inconsistent preferences it is very rare to see them applied. A fundamental part of human behavior is, therefore, completely neglected by standard economic theory! That's weird, and frankly, makes economics look silly.
         This divorce between reality and theory is a consequence of economists becoming trapped in a world where people are assumed rational, even though we know people are systematically biased in many ways. To date, behavioral economics has done nothing more than chip away at the edges of this monolith. Hopefully, things will change in the future.
       But, what of the liberalization of the pension rules? Some argue that because of time-inconsistent preferences the changes will be harmful. And, no doubt there will be some who blow their pension money in a way they subsequently regret. The old system, however, forced everyone to buy an annuity despite their being many for whom this was not the best option. Trading off the interests of some against others is always difficult. But, I think the old system was clearly weighted too much on the side of those likely to blow the money. Many were having to choose bad options for the benefit of a few who could not be trusted to spend the money wisely.
          Present bias does exist, however. And so it is still important to try and nudge pensioners to spend their money wisely. Note, though, a fundamental characteristic of a good nudge - it should not limit the options available. The pension reforms announced by the government fit this model - they liberalize choice while still nudging pensioners in the direction that will be sensible for most.

Wednesday, 19 March 2014

Breastfeeding, externalities and the Coase Theorem

Saturday morning I heard a somewhat intense debate on the radio about whether a mother should breast-feed in public. The debate was sparked by an incident in a restaurant where a breast-feeding mother was asked to 'use a blanket'. Views were completely polarized. Some, like me, thought it outrageous to criticize someone for breast-feeding in public. Others, thought it outrageous to breast-feed in public! This polarization of views is a perfect illustration of the reciprocal nature of externalities, first pointed out by Ronald Coase.
        The 'textbook' picture of an externality is typically one of good and evil, like a factory polluting the water that local people drink. The clear suggestion is that the evil doer, the factory in this case, should take account of the effect they have on others. Often, however, externalities do not lend themselves to a simple good and evil. That's the case in the breast-feeding example: Some would place the breast-feeding mother in the role of evil and others would place the person complaining about breast-feeding in the role of evil.
        Given that the breast-feeding example has no clear distinction between good and evil the reciprocal nature of externalities is simpler to appreciate. In particular, a woman's breast-feeding in public creates a negative externality for those who do not want to watch someone breast-feeding. But, banning breast-feeding in public creates a negative externality for any mother forced to feed her baby in the wash-room. To stop a negative externality inevitably creates a different kind of negative externality. And note that this holds even if we have a clear distinction between good or evil. To ban water pollution, for example, imposes a negative externality on the factory.
         An appreciation of the reciprocal nature of externalities led to Coase's celebrated theorem on how to increase efficiency in the presence of externalities. The theory essentially says that if there are clearly defined property rights (and negotiation costs are negligible) interested parties will negotiate towards an efficient outcome no matter who owns the property rights. For example, if local people have the property right they could charge the factory for its pollution. While, if the factory has the property right it could be paid by local people to reduce pollution. Similarly, if the person who does not like to see breast-feeding has the property right she could charge someone for breast-feeding. While if the person who breast-feeds has the property right she could be paid to breast-feed in the wash-room. These charges or payments correct incentives and 'eliminate' the externality.
          Well, that is the theory. In practice, I think the breast-feeding example points to a fundamental floor in the application of the Coase Theorem. We know that people dislike 'unfair' outcomes. And that they would rather 'suffer' than accept an unfair outcome. This suggests that someone may be unwilling to negotiate towards an efficient outcome unless they believe that they are in the position of evil. Consider, for instance, the factory example: The idea that the factory would compensate local people for pollution seems entirely reasonable. The idea that local people would pay the factory to reduce pollution clangs with common sense. And what about the breast-feeding example: If the breast-feeding mother believes it is her basic right to breast-feed in public she is not going to want to pay to breast-feed. And if the person who does not like to see breast-feeding believes it is her basic right to not see breast-feeding she is not going to want to compensate someone for not breast-feeding.
          The basic point here is that an assignment of property rights does not change beliefs. British law clearly gives the property right to the breast-feeding mother, but that does not change the beliefs of the person who does not want to see breast-feeding. In a similar way, British law clearly gives the property right to people who do not smoke cigarettes, but that does not change the beliefs of the those who think they have the right to smoke. The Coase Theorem may, therefore, be of somewhat limited applicability. So, while it is important for governments to assign property rights for distributional reasons, as in the breast-feeding case, do not expect to see the most efficient outcome as a consequence.

Friday, 14 March 2014

Add-on insurance and default options

One of the most basic and intuitive ideas that has come out of the behavioural change literature is the opt-in versus opt-out distinction. Essentially, because of psychological bias, people are likely to end up 'choosing' the default option. So if, for example, the default option is to not be opted into a pension savings plan a person is likely to end up not saving enough for retirement. This simple observation partly motivated the save more tomorrow plan that stands to revolutionise retirement saving.
        A context where default options are often used strategically is check boxes on online (or hard copy) forms. Suppose, for example, you want to travel from London to Birmingham and go to book your ticket online. If you are going by train then once you've sorted out the times of the trains etc. you will be offered the chance to buy basic travel insurance. In this case the box is not ticked and so the default option is no travel insurance - you have to click a mouse button to get insurance. If you are going by coach, by contrast, the box is ticked and so the default option is travel insurance - you have to click a mouse button to remove the insurance. The Financial Conduct Authority is concerned that such default opt-in options are essentially a form of miss-selling and so should be banned.
         To the standard economic model this all seems a little crazy. There is seemingly no-cost at all in clicking a mouse button to switch from opt-in to opt-out. And travel insurance is a product that some people might want to buy. So, why should we be banning default opt-in options? Should we not put the onus on consumers to make sensible decisions?
         To get some insight on these questions I think we need to take a step back and ask why default options matter. The standard reason given for why defaults matter is procrastination. A person, for instance, puts off changing their pension plans, until tomorrow, and then the day after, and then the day after that. Before long they have retired without the savings they hoped they would have. But, while this can explain the success of the save more tomorrow plan it says nothing about online check boxes. In the latter case the form is being filled here and now and so the decision simply cannot be left until tomorrow.
          We need, therefore, to question why defaults can matter beyond procrastination. I'll point to two reasons. First, we have a psychology bias to 'trust the seller knows what we want'. We naively think that the default option must be the right option - why else would it be the default. A little thought shows that this logic is really na├»ve - the seller wants to make as much profit as possible. But, we still fall for the trap. And things get worse when we take into account a second factor, namely that of anticipated regret. By unchecking the box to buy default travel insurance you set yourself up to feel regret if the insurance would subsequently have been useful. The fear of that regret may bias you towards sticking with the insurance. This is a variant of the endowment effect - you value something more when you feel you already own it. Observe how ridiculous this can end up being: When you sat down to buy the tickets you had no thoughts about travel insurance. But once the 'seed is in your head' and you have to 'consciously do something' to opt-out, travel insurance suddenly seems an essential!
          Seen in this light, I think the Authority is right to get involved and ban default opt-ins. They are essentially a way of 'fooling' the customer into feeling they need something they do not. To say that consumers have the choice to opt-out is not really the point. Consumers are forced to consciously opt-out of something and pay the psychological cost for doing that. Indeed, notice that everyone suffers - some buy something they do not need, while others pay (a small) psychological cost of 'giving something up'. If travel insurance is worth buying the onus should be on the company to prove its worth buying.