Behavioral Economics and Economic Policy

Robert H. FrankCornell University

Johnson Graduate School of Management

Adam Smith’s invisible hand:

Self-interested demands will result in a socially efficient allocation.

Why do markets often fail?

World B: You and your family live in a neighborhoods with 3000-square-foot houses, others in neighborhoods with 2000-square-foot houses.

Which world would you choose?

World A: You and your family live in a neighborhood with 4000-square-foot houses, others in neighborhoods with 6000-square-foot houses.

Which world would you choose?

A: You have 4 weeks of vacation each year, others have 6 weeks?

or

B: You have 2 weeks of vacation each year, others have 1 week?

Housing = positional good

Leisure = nonpositional good

1.People care about relative consumption, more in some domains than in others.

2. Such concerns lead to positional arms races--expenditure arms races focused on positional goods.

3. These arms races divert resources from nonpositional goods, causing large welfare losses.

4. The welfare losses have been made worse by rising income inequality.

The Conflict Between Individual and Group

Robert H. Frank. “The Demand for Unobservable and Other Nonpositional Goods.” American Economic Review, 75, March, 1985, pp. 101-116.

Charles Darwin: Traits are selected because of their impact on the reproductive fitness of individuals, not groups.

Traits that benefit individuals often work to the disadvantage of groups.

Big antlers: Smart for one, dumb for all.

Happiness and Income (Easterlin,1974)

1. Happiness levels within a country tend to be highly stable over time, even in the face of significant economic growth.

| | | | | | | | | | | | | | | | | | | | | | | | | |196 1 196 3 196 5 1 967 1 969 1 971 1 973 1 975 1 977 1 979 1 981 1 983 19 85 19 87

10

8

6

4

2

0

Happiness

500

400

300

200

100

0

Average reported levelof well-being in surveys(10 = extremely happy)

Income

Index of Japanese GNP,

per capita (1960 = 100)

Veenhoven, 1993

2. Happiness within countries at any moment of time depends on income.

Income vs Satisfaction in the US, 1981-4. Source: Diener, Sandvik, and Seidlitz, 1993.

Which vertical line is longer?

Is my house OK?

Theoretical Considerations

People should care about relative position because it affects material payoffs

– Food in Famines

– Mate access

Are concerns about relative position hard-wired?

Neurophysiological Evidence

• Local rank vs serotonin

Local rank vs testosterone

Sister B(not employed)

Sister A

Probability that Sister A is employed is 16-25% higher when Sister B’s husband earns more than Sister A’s husband.

Source: Neumark and Postlewaite, 2000

In a poor country, a man proves to his wife that he loves her by giving her a rose. In a rich country he must give a dozen roses.

Richard Layard

The middle class family’s condition has grown more difficult because of sharply rising inequality of income and wealth.

Fractal earnings change pattern for virtually every labor market group:

Bottom quintile: Absolute earnings decline

Middle quintile: Negligible earnings growth

Top quintile: Substantial growth

College graduates

Dentists

The top 1 percent

The top 1/10th of 1 percent…

2000: 531 x average worker’s earnings

Earnings of CEOs of largest U.S. corporations

1980: 42 x average worker’s earnings

Why increased inequality?

Changes in the distribution of human capital?

Technical change favoring most educated workers?

Foreign competition at the low end?

Winner-Take-All Markets

Markets in which reward depends not just on absolute performance but also on relative performance.

Why did Steffi Graf earn twice as much in 1994 as in 1993?

The market for university presidents

Bottom-line difference: (0.03)x($4 billion) = $120 million

Suppose Cornell’s Skorton was 3% better at fundraising than the 2nd-best candidate.

Because of increased inequality, it now costs a middle-class family much more than before to achieve many important goals.

Not all costs of inequality are psychological.

If you were society’s median earner, which option would you prefer?

1) You save enough to support a comfortable standard of living in retirement, but your children attend a school whose students score in the 20th percentile on standardized tests in reading and math; or

2) you save too little to support a comfortable standard of living in retirement, but your children attend a school whose students score in the 50th percentile on those tests?

The cost of sending a child to a school of average quality is linked to the price of the average house in the community.

Median size of a newly constructed house:

1980: less than 1600 square feet

2007: more than 2300 square feet

Expenditure Cascades

• Top earners spend more because they have more money.

• And so on all the way down the income ladder.

• That, in turn, shifts the frame of reference for those next below.

• This shifts frame of reference for those just below them, who also spend more.

$10 million birthday parties

Aerosmith50 Cent

Viking Professional, $5,000.

1989 Sunbeam, $90

Gas Grills Then and Now

Talos Outdoor Cooking Suite, $35,000.

Victoria’s Secret $12.5 Million Fantasy Bra

US Personal Savings Rate

Evidence for Expenditure Cascade Hypothesis

Large U.S. counties with higher growth in 90/50 ratios* had higher growth in

Commute times

Divorce rates

Bankruptcy rates

In OECD, over time and across countries, higher 90/50 ratios are linked with longer hours of work***Frank, Levine, and Ostvik-White, 2004**Bowles and Park, 2003

Remedies for Market Failure

Why do hockey players vote in secret ballots for helmet rules, even though they choose not to wear helmets when there is no rule?

If you were society’s median earner, which option would you prefer?

A. You work in a safe job, but your children attend a school whose students score in the 20th percentile on standardized tests in reading and math; or

B. You earn a higher salary by accepting a more dangerous job, but your children attend a school whose students score in the 50th percentile on those tests?

Proposed positional arms control agreement:

Impose limits on workplace safety risks.

Public Waste vs. Private Waste

Loose Nukes: Not worth locking down?

Private waste occurs not because consumers get overcharged, but because they get caught up in wasteful “positional arms races.”

The Progressive Consumption Tax(a.k.a., the Unlimited Savings Allowance Tax)

Consumption + Savings = Income

Consumption = Income – Savings

Taxable consumption = Income – Savings – standard deduction

The Jones Family

Annual income: $50,000

Annual savings: $5,000

Standard deduction: $30,000

Taxable consumption: $50,000 - $30,000 - $5,000 = $15,000

Tax rate = 20 percent

Annual tax bill = $3,000

(About the same as under the current income tax.)

Big mansions: Smart for one, dumb for all?

Is redistributive taxation “legitimate”?

Two alternatives for meeting the same air quality target:

A. Require all cars to comply and give poor a voucher to pay for a late model used car with low emissions.

B. Exempt older vehicles and impose much stricter emissions standards on newer vehicles.

What Behavioral Economics Teaches Us about the Current Economic Crisis

Herbert Hoover

Spend More Right Away

John Maynard Keynes

The General Theory of Employment, Interest, and

Money, 1936

Even useless activities can be effective stimulus.

But useful activities are clearly better.

Standard model assumes

1. People are properly attentive to all relevant costs and benefits.

2.Utility depends only on absolute consumption.

Why did the crisis happen?

Should we try to do something about global warming?

QuickTime™ and a decompressor

are needed to see this picture.

Climate change forecasts are extremely uncertain.

A 7-degree C temperature rise would mean the end of life on earth.

Ford Bronco15 mpg

Ford Focus32 mpg

Acid Rain and the Market for SO2 Permits

“The claim that global warming is caused by man-made emissions is simply untrue and not based on sound science.”

Senator James Inhofe (R, Oklahoma)

“Global warming is bad, but it doesn’t make us feel nauseated or angry or disgraced, and thus we don’t feel compelled to rail against it as we do against other momentous threats to our species, such as flag burning.”

Dan Gilbert

A tax on any activity has two effects:

1. It generates revenue.

2. It discourages the activity.

The current tax system taxes mostly useful activities, such as savings and job creation.

If we instead taxed only harmful activities, we could raise all the revenue we need without requiring any painful sacrifices.