Behavioral economics among regulators

Arnold Kling, blogging at Library of Economics and Liberty, points to this Matt Ridley paper, which explores how the behavioral economic phenomena that clutter free market theory also can apply to regulators.

Recall behavioral economics studies how people do not always act rationally to maximize wealth (or more formally, their utility function). For example, given two options people will sacrifice to avoid pain, even if it results in a better outcome.

Kling is fond of something called the Illusion of Explanatory Depth, where people think they know more than they do. From the paper:

We falsely believe that we understand the causes, effects and inner mechanics of different things, events or processes much better than we actually do. Participants in the experiments testing for this illusion would consistently report a certain level of understanding of the given phenomena, before hearing an expert explanation of the same. Only after finding out the true explanation would they realize that their understanding was poor.

I suppose the link to regulators is pretty obvious. Consultants – of which I am one – can fall prey to this as well. If you’ve ever been an insider and observed outsiders commenting on your situation, you know how simplistic their analysis can seem.

In fairness, I’d point out the paper uses examples of everyday people who profess to know how a helicopter works, but then can’t explain the dynamics. They know what makes it hover, but they can’t explain how it moves forward.

This is an experiment asking for a sophisticated response from unsophisticated observers, and the gap in knowledge is huge. For a competent regulator, the knowledge gap is considerably smaller, so the decisions would presumably be better.

Other phenomena seem more interesting to me:

  • Action bias – the tendency to do something even when action may not be warranted. I’ve written before about goalkeepers, who tend to dive left or right on a penalty kick, when the best response is to do nothing. Again, the link to regulatory behavior seems obvious.
  • Motivated reasoning – the tendency to logically conclude what we already emotionally believe. For a regulator, the bias would be to regulate, so his chain of reasoning will tend to conclude that more regulation is needed.
  • Focusing illusion – overestimating the importance of one factor in a situation. The paper points to Too Big To Fail policies, where the benefits of action are known since it is concentrated in a few banks while the costs, being spread among many taxpayers are hard to assess. Not sure that’s the example I’d use, but the idea is interesting.
  • The affect heuristic – overestimating risks and underestimating benefits from activities we think are undesirable. We tend to dislike air travel so we overestimate the risks in travel and underestimate the benefits. The paper points to solar energy as a place where regulators may underestimate the risks and overestimate the benefits.

You can probably tell I’m a little skeptical on the specifics, but I think the overall idea – that regulatory policy is susceptible to the same bias as the efficient market – is one that should always be considered when new policy is developed.

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