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Public Policy and Bounded Rationality Bounded Rationality and Public Policy THE ECONOMICS OF NON-MARKET GOODS AND RESOURCES VOLUME 12 Series Editor: Dr. Ian J. Bateman Dr. Ian J. Bateman is Professor of Environmental Economics at the School of Environmen- tal Sciences, University of East Anglia (UEA) and directs the research theme Innovation in Decision Support (Tools and Methods) within the Programme on Environmental Decision Making (PEDM) at the Centre for Social and Economic Research on the Global Environment (CSERGE), UEA. The PEDM is funded by the UK Economic and Social Research Council. Professor Bateman is also a member of the Centre for the Economic and Behavioural Anal- ysis of Risk and Decision (CEBARD) at UEA and Executive Editor of Environmental and Resource Economics, an international journal published in cooperation with the European Association of Environmental and Resource Economists. (EAERE). Aims and Scope The volumes which comprise The Economics of Non-Market Goods and Resources series have been specially commissioned to bring a new perspective to the greatest economic chal- lenge facing society in the 21st Century; the successful incorporation of non-market goods within economic decision making. Only by addressing the complexity of the underlying issues raised by such a task can society hope to redirect global economies onto paths of sustainable development. To this end the series combines and contrasts perspectives from environmental, ecological and resource economics and contains a variety of volumes which will appeal to students, researchers, and decision makers at a range of expertise levels. The series will initially address two themes, the first examining the ways in which economists assess the value of non-market goods, the second looking at approaches to the sustainable use and management of such goods. These will be supplemented with further texts examining the fundamental theoretical and applied problems raised by public good decision making. For further information about the series and how to order, please visit our Website http://www.springer.com/series/5919 Bounded Rationality and Public Policy A Perspective from Behavioural Economics Alistair Munro National Graduate Institute for Policy Studies, Tokyo, Japan and Department of Economics, Royal Holloway, University of London, Egham, Surrey, UK 123 Alistair Munro National Graduate Institute for Policy Studies 7-22-1 Roppongi, Minato-ku Tokyo, 106-8677 Japan And Department of Economics Royal Holloway, University of London Egham, Surrey, TW20 0EX, UK ISSN 1571-487X ISBN 978-1-4020-9472-9 e-ISBN 978-1-4020-9473-6 DOI 10.1007/978-1-4020-9473-6 Springer Dordrecht Heidelberg London New York Library of Congress Control Number: 2008940653 c Springer Science + Business Media B.V. 2009 No part of this work may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, microfilming, recording or otherwise, without written permission from the Publisher, with the exception of any material supplied specifically for the purpose of being entered and executed on a computer system, for exclusive use by the purchaser of the work. Cover Image: c 2008 JupiterImage Corporation Cover design: Integra Software Services Pvt. Ltd. Printed on acid-free paper Springer is part of Springer Science+Business Media (www.springer.com) For my daughter, Hana, whose rationality becomes less bounded with each day. Preface This book is about bounded rationality and public policy. It is written from the per- spective of someone trained in public economics who has encountered the enormous literature on experiments in decision-making and wonders what implications it has for the normative aspects of public policy. Though there are a few new results or models, to a large degree the book is synthetic in tone, bringing together disparate literatures and seeking some accommodation between them. It has had a long genesis. It began with a draft of a few chapters in 2000, but has expanded in scope and size as the literature on behavioural economics has grown. At some point I realised that the geometric growth of behavioural re- search and the arithmetic growth of my writing were inconsistent with an ambi- tion to be exhaustive. As such therefore I have concentrated on particular areas of behavioural economics and bounded rationality. The resulting book is laid out as follows: Chapter 1 provides an overview of the rest of the book, goes through some basic definitions and identifies themes. Chapter 2 is devoted to a survey of some of the evidence on anomalies. There are several excellent summaries of this literature including those by Colin Camerer (1995) and by Chris Starmer (2000). My aim is not to be systematic therefore, but to show that the evidence is substantial and that it points to predictable deviations from rational behaviour in many arenas of economic activity. The emphasis in this chapter is on anomalies found in static choice situations. Discussion of dynamic choice anomalies, learning and those associated with information processing are found later in the book. Chapter 3 is a sequel and companion to Chapter 2 in the material it contains: I discuss evidence and theories about learning. The key issue here is whether re- peated choice opportunities and the framing created by the marketplace lead to the elimination of anomalies. Some evidence on information processing is therefore also in this chapter. While Chapter 3 considers the impact of markets on anomalies, Chapter 4 ex- amines how deviations from consistency affect the organisation of markets. The theme in this chapter is that bounded rationality can say something about mar- ket behaviour and in some situations claims about the efficiency of markets can be made. vii viii Preface Chapter 5 is the welfare chapter. I tackle the tricky and possibly intractable issue of the normative implications of the data discussed in Chapter 3, looking at alterna- tives to standard welfare economics. Chapter 6 is a summary chapter on public policy and bounded rationality. A central purpose is to clarify the relationship between bounded rationality on the one hand and traditional notions of market failure on the other hand. I also consider the direct implications of bounded rationality for the role of the state. In Chapter 7 I review some of the existing literature on merit wants. The purpose is draw out its major conclusions and to show its limitations as a theory of policy. In particular I argue that its main weakness is in the general absence of articulated models of why preferences deviate from individual welfare. Chapter 8 provides a discussion of the neglected role of agents. The fact that someone else knows what is best for another individual does not mean that they will be motivated to reveal that knowledge or, if given the power to act, that they will make choices which raise the welfare of their principal. While government or a group of experts may hold better information about welfare in some cases, in many other cases it is close friends or family who know best. In Chapter 8 I focus on the second case, which has been largely neglected in the literature on agency. The main focus of Chapter 9 is tax policy when the policy maker has only lim- ited information on individual welfare rankings. In what sense can we still promote efficiency as a desirable economic goal? Are some tax changes still likely to be desirable? While Chapter 9 is devoted to manipulations of the budget set, Chapter 10 fo- cuses on manipulations of the frame as an instrument of policy. I also discuss some intertemporal anomalies here in the context of savings policy, an area that has seen much interest from behavioural economists. Chapter 11 concludes the major arguments of the book with a practical applica- tion of some of the arguments from Chapter 5 applied to the problem of non-market valuation. Much debate has occurred in recent years on the future of stated prefer- ence methods in the face of evidence on their unreliability. The conclusion drawn here is that decisions on the usefulness of contingent valuation and its allied methods for valuation should be comparative – i.e. based on an evaluation of the costs and benefits of alternative methods of making decisions. So, we compare stated pref- erence methods to its alternatives and rivals in a framework drawn from decision theory. In terms of routes through the book, readers familiar with the literature on anoma- lies may wish to skip Chapters 2–4 and proceed to Chapter 5. Readers particularly interested in non-market valuation may find it useful to proceed via Chapters 2–5 and then directly to Chapter 11. Tax policy is to the fore in Chapters 7, 9 and 10. As with any research enterprise I have picked up intellectual debts along the way. Mick Common and Nick Hanley at the University of Stirling provided my first exposure to environmental economics and contingent valuation. The experimental group at University of East Anglia, notably Robin Cubitt, Chris Starmer and Bob Sugden deserve special thanks for introducing me to the startling notion that theo- ries of economic behaviour were testable in the laboratory. Last but not least, Ian Preface ix Bateman has been a close collaborator for many years and from him I have learnt a great deal about environmental valuation in particular and research in general. Egham, Surrey, UK Alistair Munro Contents 1 Introduction .................................................. 1 1.1 MeritWants.............................................. 3 1.1.1 The Link Between Bounded Rationality and Merit Wants 3 1.1.2 Other-Regarding Behaviour and Expressive Preferences . 4 1.2 Definitions............................................... 5 1.2.1 Frames .......................................... 6 1.2.2 FramesandWelfare................................ 8 1.2.3 Uncertainty and Information Processing . .............. 10 1.2.4 Merit Goods . .................................... 11 1.3 MainPoints .............................................. 13 2 Anomalies ...................................................
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