School of Economics and Centre for Competition Policy University of East Anglia Norwich NR4 7TJ, United Kingdom

1. School of Economics and Centre for Competition Policy University of East Anglia Norwich NR4 7TJ, United Kingdom Why incoherent preferences do not justify paternalism Robert Sugden Paper prepared for seminar at Financial Services Authority, 5 October 2011

2. There is a long tradition of liberal thought in which the market is seen as an institution in which privately-motivated individual actions produce consequences that are socially beneficial... ... and often more beneficial than can be produced by deliberate planning. The most famous statement of this idea is Adam Smith’s Wealth of Nations. 2

3. The invisible hand … by directing that industry in such a manner as may be of the greatest value, [the merchant] intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for society that is was no part of it. … Adam Smith, Wealth of Nations, 1776, p. 456. 3

4. The liberal tradition in economics isn’t dogmatically laissez-faire. But it favours market and market-like mechanisms, even when dealing with externalities, public goods, or distributional issues ... -- cash rather than in-kind transfers; -- Pigou taxes/ tradable permit solutions to externality problems; -- cost-benefit analysis (as ‘market simulation’) to determine provision of public goods. Background idea is still that spontaneous-order market mechanisms tend to work well, i.e. the invisible hand. 4

5. In this talk, I defend the idea of the invisible hand against a new challenge, from behavioural welfare economics, and sketch an alternative way of reconciling behavioural and normative economics. My perspective: -- I’m a behavioural economist who is sceptical of neoclassical rationality assumptions; -- and a normative economist with classical-liberal, anti-paternalist sympathies; -- I’m not arguing for a neo-con or libertarian reconstruction of normative economics, just trying to conserve/ refurbish a strand of thought that has been a major part of economics for over 200 years. 5

6. Why the findings of behavioural economics cause problems for normative economics From the early 20th century, the dominant form of economics has been neoclassical. A fundamental assumption of neoclassical theory is that individuals have coherent preferences over all relevant economic outcomes, and act according to those preferences (= ‘maximise utility’). ‘Coherent’ preferences are: -- stable (i.e. not subject to random or arbitrary variation); -- context-independent (i.e. not affected by arbitrary changes of ‘framing’ of decision problems); -- internally consistent (i.e. satisfying ‘rationality’ principles such as transitivity). 6

7. In neoclassical welfare economics, the normative criterion is the satisfaction of preferences: -- Fundamental theorems of welfare economics show that competitive equilibrium is Pareto-efficient, and that any Pareto-efficient resource allocation can be achieved as a competitive equilibrium if combined with appropriate income transfers. Hence presumption in favour of markets, with regulation to prevent fraud and ensure competition. -- If there are public goods or externalities, interventions can simulate the efficiency properties of markets if they are based on cost-benefit analysis (i.e. use individuals’ willingness to pay as the measure of value). A recurring theme in neoclassical (and classical) economics: anti-paternalism, ‘consumer sovereignty’. In neoclassical economics, this is seen as equivalent to using preference-satisfaction as the normative criterion. 7

8. But the findings of behavioural economics (i.e. use of research methods and theoretical ideas adapted from psychology) cast doubt on whether coherent preferences really exist. In many cases, individuals’ economic behaviour reveals incoherentpreferences; the incoherencies (‘anomalies’) are systematic and can be explained psychologically. For example: -- preferences between two options depend on which is perceived as the status quo (the ‘endowment effect’, ‘loss aversion’); -- preference between A and B varies according to whether C is in the opportunity set (‘decoy effect’: if C is clearly inferior to B, but not to A, adding C to the set makes B more attractive). If preferences are incoherent, how can preference-satisfaction be used as a normative standard? (And so: what is left of the claim that competitive markets satisfy consumer preferences?) 8

9. In behavioural economics, a consensus seems to be developing around a particular response to this problem: libertarian paternalism/ asymmetric paternalism/ soft paternalism/ behavioural welfare economics. This has become influential both within academia and outside: -- Richard Thaler and Cass Sunstein’s popular book Nudge; -- Thaler recently visited 10 Downing Street to advise the ‘behavioural insight team’ or ‘Nudge unit’ on how to apply his approach to public policy. This presentation: -- presents a critique of this approach; -- gives a very quick sketch of an alternative approach that I am developing. Based on a series of papers, including: American Economic Review 2004; Social Choice and Welfare 2007; Constitutional Political Economy 2008; Economics and Philosophy 2008 (with Bruni); Journal of Environmental Economics and Policy 2009; review of Nudge in International Journal of the Economics of Business 2009; Economics and Philosophy 2010. 9

10. NB: I am criticising the theoretical approach of behavioural welfare economics, not any specific policy proposals that have been made under the libertarian paternalist banner. The issue I address is: What normative criterion should be used in assessing proposals for the regulation of markets? 10

11. Behavioural welfare economics Two (remarkably similar) manifestos appeared in 2003: Cass Sunstein and Richard Thaler. Libertarian paternalism is not an oxymoron. University of Chicago Law Review 2003 [The academic paper that was expanded and popularised as Nudge.] Colin Camerer, Samuel Issacharoff, George Loewenstein, Ted O’Donaghue and Matthew Rabin (2003). Regulation for conservatives: behavioral economics and the case for ‘asymmetric paternalism’. University of Pennsylvania Law Review 2003. Each paper has a legal scholar as a co-author. Otherwise, a roll-call of the great and the good of American behavioural economics. Titles (‘libertarian paternalism’, ‘regulation for conservatives’) signal that the authors will propose interventions in the economy that have traditionally been opposed by pro-market thinkers – but the authors’ arguments will be immune to their opponents’ usual criticisms. 11

12. I’ll focus on the version of behavioural welfare economics presented by Sunstein and Thaler. Richard Thaler Cass Sunstein And I’ll focus on one of Sunstein and Thaler’s central claims: -- The findings of behavioural economics show that paternalism is ‘inevitable’;the idea that there are ‘viable alternatives to paternalism’ is a ‘misconception’; the anti-paternalist position is ‘incoherent’, a‘nonstarter’. So .... 12

13. ... planners/choice architects ought to be consciously paternalistic: ‘we argue for self-conscious efforts, by private and public institutions, to steer people’s choices in directions that will improve their own welfare’ (Sunstein and Thaler, 2003). But (especially in more recent work): their recommendations are designed to ‘make choosers better off, as judged by themselves’. [S&T’s italics] (What ‘as judged by themselves’ means is part of my topic.) 13

14. Why (according to Sunstein and Thaler) is paternalism inevitable? Sunstein and Thaler conceive of themselves as advising a ‘planner’ (later: ‘choice architect’) who is responsible for designing the presentation of options to individuals. Their favourite example: the cafeteria. The cafeteria director chooses the display of the food items, knowing that this affects customers’ purchases. They say: an anti-paternalist’s recommendation to the director would be: ‘give customers what she thinks they would choose on their own’. S&T say: this recommendation is meaningful only if ‘what the customer would choose’ can be defined independently of the director’s choice. But it can’t: ‘consumers … lack well-formed preferences, in the sense of preferences that are firmly held and preexist the director’s own choices about how to order the relevant items [in the display]. If the arrangement of the alternatives has a significant effect on the selections the customers make, then their true ‘preferences’ do not formally exist.’ 14

15. Since the cafeteria director can’t avoid influencing consumers’ choices, she should recognise this and ‘make choices that she thinks would make the customers best off, all things considered’. This is paternalism, but of an inoffensive kind, because it’s only a nudge: customers’ freedom of choice is not constrained. -- This respects autonomy (i.e. acceptable to principled ‘libertarians’); -- and ensures that coherent preferences are satisfied. 15

16. What is the normative criterion? The Nudge approach requires a criterion of ‘better off, all things considered, as judged by herself’. Compare neoclassical welfare economics, which has (what was assumed to be) a well-defined and objective (i.e. observer-independent) criterion: revealed preference. S&T spend much more time discussing how people can be nudged than on how the planner decides in which direction to nudge them (just unspecific appeals to ‘cost-benefit analysis’ – without saying that standard CBA uses preference-satisfaction as the criterion). But their official position (as far as I can decipher it) is to use an informed desire or true preference criterion... 16

17. Starting point for Nudge: ‘individuals make pretty bad decisions – decisions they would not have made if they had paid full attention and possessed complete information, unlimited cognitive abilities, and complete self-control’. In 2003 paper: individuals are treated as not acting in their own best interests if their decisions are ones ‘they would change if they had complete information, unlimited cognitive abilities, and no lack of willpower’. Implication: a person’s ‘best interests, as judged by himself’ correspond with the preferences he would reveal if he paid full attention and possessed complete information, unlimited cognitive abilities, and no lack of willpower. Reasons for concern about this informed desire criterion... 17

18. Reasons for concern: 1. It uses a normative and contestable concept of an ideally rational agent. Full attention, complete information, unlimited cognitive ability, complete self-control are all normative concepts. E.g. the obese customer who buys the Home Wrecker at Hillbilly Hot Dogs. On his first day in Huntington, W. Va., Jamie Oliver spent the afternoon at Hillbilly Hot Dogs. … He learned how to perfect the Home Wrecker, the eatery’s famous 15-inch, one-pound hot dog (boil first, then grill in butter). For the Home Wrecker Challenge, the dog gets 11 toppings, including chili sauce, jalapeños, liquid nacho cheese and coleslaw. Finish it in 12 minutes or less and you get a T-shirt. [Times magazine 6 Oct 2009] 18

19. What is true information about diet/ health links? (In a model, ‘complete information’ is an objective concept – but not in the real world!) What is correct reasoning about health risks? What is the distinction between changing one’s mind and lacking self-control? Very easy for the nudger to attribute his own judgements to the ‘ideally rational’ version of the nudgee. Sunstein and Thaler’s attributions are very casual… 19

20. E.g. arguing for nudges to advocate nudges against obesity-inducing diets, smoking, drinking… … Sunstein and Thaler just report familiar statistics about the associated health risks and conclude: ‘With respect to diet, smoking, and drinking, people’s current choices cannot reasonably be claimed to be the best means of promoting their well-being.’ No suggestion that S&T need to verify that nudgees are making bad decisions as judged by themselves. 20

21. S&T sometimes claim that nudgees have expressed desires to make the choices they will be nudged to make – and so have acknowledged a self-control problem. But again, very casual argument… The‘New Year resolution test’: ‘[H]ow many people vow to smoke more cigarettes, drink more martinis, or have more chocolate donuts in the morning next year?’ On saving: they cite survey evidence that two-thirds of employees describe their savings rate as ‘too low’ while only one per cent describe it as ‘too high’. S&T: such statements ‘are not meaningless or random’; they show that people‘are open to a nudge’and‘might even be grateful for one’. Subtext: We’re only nudging, so paternalism doesn’t need rigorous justification. 21

22. Reasons for concern about the informed desire criterion… 2. It assumes that, deep down, individuals have rational preferences. S&T are assuming that, inside every ‘behavioural’ human being, there is a neoclassical rational agent. The rational agent’s optimal choices are frustrated by imperfections that are ‘external’ to it, (lack of attention, imperfect information, imperfect cognition, imperfect self-control). This idea doesn’t fit with the methodology of behavioural economics – the concept of true preferences comes from rational choice theory, not pychology. Information, cognition and willpower are inert without desires to act on. Superhuman agents who had perfect information, perfect cognitive powers and perfect willpower would still have to deal with their actual desires, which are matters of psychology, not rationality. ‘Anomalies’ in human decision-making (i.e. deviations from rational-choice theory) may reflect the structure of desires (e.g. loss aversion), not ‘error’. If individuals don’t have ‘true’ preferences, S&T’s claim that they are only helping people to choose what they really prefer is an illusion. 22

23. An alternative approach Starting point: notice the mismatch between the liberal tradition (Hume, Smith, JS Mill...) and the idea of defending the market by taking the viewpoint of a planner, for whom individuals’ choices are just a source of data. Why is the addressee of normative economics ‘the planner’? Who else could be the addressee? Each of us as private individuals. So, in relation to the market (and proposals for regulation), each of us can ask: What does the market do for me? Does it work in my interests? A contractariandefence of an economic system shows each person severally that it tends to give him what he wants; there is no need to imagine a planner. 23

24. Behavioural and neoclassical welfare economics interpret the invisible hand argument as claiming that markets are effective in satisfying given preferences. (First we specify preferences, then we ask whether the market satisfies them.) I propose that we reformulate the invisible hand argument as claiming that markets allow individuals to satisfy their preferences, whatever those preferences turn out to be. (We evaluate the market from the perspective of individuals who do not yet know what their preferences will be.) Preference inconsistencies disable the first approach, but not the second. 24

25. Reconstructing the first fundamental theorem of welfare economics This theorem is generally seen as the core neoclassical statement of the invisible hand argument. Roughly, it says that competitive markets are efficient in satisfying preferences. I’ll show how the theorem can be reconstructed so that it doesn’t refer to given preferences. (Just the first step in a bigger project ...) First, I’ll state the theorem more precisely, as applied to a very simple exchange economy. 25

26. In this economy, there are many individuals. There are many goods, all of which are private. There is a fixed stock of each good, so the only economic problem is to divide these stocks between individuals. Any division of goods between individuals is an allocation. We start with an initial allocation (individuals’ endowments). Individuals are then able to exchange goods by mutual consent. Competitive equilibrium is a list of prices, one for each good, such that all markets clear (i.e. for each good, total amount offered for sale = total amount demanded). Trade at these prices brings about a new allocation. It’s assumed that each individual has a ‘given’ preference ranking over all bundles of goods, and acts on this. An allocation is Pareto-optimal if no feasible reallocation of goods between individuals would make some individual better off and no one worse off (in terms of their preferences). The theorem tells us: every competitive equilibrium is Pareto-optimal.

27. A sketch of a proof of the first fundamental theorem Deliberately, the proof is not quite standard. It proves as much as possible using only the most minimal assumptions about preferences, and introduces rationality assumptions at the very end. This allows us to identify desirable properties of the market that don’t depend on rationality assumptions. Preliminary. Competitive equilibrium can be defined without using the concept of preference (or ‘utility’). Conventionally, ‘demand’ and ‘supply’ (and hence market-clearing) are defined in terms of utility-maximising choices. But all we need to assume is that individuals make decisions about how much to buy and sell at the prices that are on offer. These decisions need not reveal consistent preferences (e.g. desired holdings of goods may depend on endowments, and/or on ‘arbitrary’ framing features). All I assume about preferences is that one good (‘money’) is always desired. 27

28. A possible doubt: Competitive equilibrium is defined as a list of market-clearing prices. In neoclassical welfare economics, this is treated as an idealised representation of the outcome of real markets. For this idea to be plausible, do we need to assume that individuals have consistent preferences? No. It’s sufficient that trades are mediated by profit-seeking professional traders (who are ‘rational’ in their professional activities). No one needs to have consistent preferences over bundles of goods. [I show this in a paper in American Economic Review 2004.] But (very relevant for financial regulation): ‘rational’ traders are assumed to be non-colluding and profit-seeking, and to have correct expectations (in equilibrium). Argument would not work if traders did not bear the downside risks of their trades. 28

29. Step 1 of proof: In competitive equilibrium, all opportunities for voluntary transactions have been made available to individuals (severally). Let Z be the initial allocation. Let X be the allocation reached in a competitive equilibrium, by trades from Z made at the price list P. What would it mean to say that some opportunity for voluntary transaction had not been made available? Suppose that were so. Then there would be: (a) a feasible allocation Y (not the same as X), reachable from X by some composite transaction; and (b) no party to that composite transaction (i.e. no individual whose bundle in Y is not the same as his bundle in X) has been offered his part of the transaction and has rejected it. But in fact, for any Y satisfying (a): at least one party to that transaction was offered his part of it through the market, and chose not to take it. 29

30. How do we know this? X (the outcome of the market) and Y (the outcome of the composite transaction) contain exactly the same goods. (In this economy, the only possible transactions are exchanges.) So: value of Y at market prices = value of X at market prices. For each party to the transaction we can ask whether his Y-bundle is worth more or less (at market prices) than his X-bundle. Clearly, it can’t be the case that every party ‘gains value’ in the transaction. So there must be at least one individual i, who is a party to the transaction, and whose Y-bundle is worth no more than his X-bundle. But i had the opportunity to buy his Y-bundle (or one unambiguously better) at the market prices, and chose not to do so. Which proves: In competitive equilibrium, all feasible opportunities for voluntary transactions have been made available to individuals. 30

31. Step 2 of proof:If each individual acts in accordance with a stable preference ordering, then competitive equilibrium is Pareto-optimal. For simplicity, I assume that preferences are strictly convex (i.e. there is a uniquely optimal choice from every budget constraint) – this isn’t essential. From Step 1, we know that if X is the outcome of the market, then for every other feasible allocation Y, there is at least one individual i who chose not to take his Y-bundle in exchange for his X-bundle. So, i prefers his X-bundle. So, every feasible reallocation of X makes at least one individual worse off. QED. 31

32. The significance of this proof: Behavioural welfare economists claim that the invisible hand argument is undermined if individuals lack coherent preferences. But coherent preferences are needed only for Step 2. Step 2 converts ‘In competitive equilibrium, all opportunities for voluntary transactions are made available’ into‘Competitive equilibrium is Pareto-optimal’. This step switches from individuals’ perspectives to the planner’s perspective. The planner is trying to maximise each individual’s welfare; she treats ‘given’ preferences as indicators of welfare; so she needs to show that opportunities for voluntary transactions translate into the satisfaction of given preferences. But: For each of us as individuals, assessing what the market does for us, isn’t ‘All opportunities for voluntary transactions are made available’sufficient? Do we need the planner’s viewpoint? 32

33. Some generalisations of this result: 1. Generalise to many time periods. We show that the market makes available all feasible opportunities for voluntary transactions, where these include exchange between an individual’s ‘period 1 self’ and ‘period 2 self’. The opportunity criterion treats these as opportunities for the individual as a continuing person (or ‘locus of responsibility’). [E.g. The ‘wine economy’: arbitrageurs anticipate systematic changes in individuals’ preferences.] 33

34. 2. Generalise to public goods? An example: the argument extends to economies in which emission of pollutants is regulated by cap and trade systems. Given any cap on emissions (treated as an exogenous constraint) a cap and trade regime makes available all feasible opportunties for voluntary transactions in private goods, given that constraint. Again: no assumption that preferences are coherent. 34

35. Conclusion A competitive market provides maximal opportunities for voluntary transactions, i.e. transactions that individuals choose to make at the time they make them. Or: let us say that a person is willing to pay for a good if she is willing to give up what would induce others (or herself at another point in time) to supply it. Then my answer to the question ‘What does the market do for you?’ is: The market gives each person, rational or irrational, what she wants and is willing to pay for, when she wants it and is willing to pay for it. 35

36. Thank you for listening. 36