July 9, 2015

Behavioral Public Choice: The Behavioral Paradox of Government Policy

  • W. Kip Viscusi

  • Ted Gayer

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What are the economic justifications for government intervention in the economy? In a market economy, prices coordinate the activities of buyers and sellers and convey information about the strength of consumer demand for a good and the costs of supplying it. Because trade is voluntary, buyers and sellers only make exchanges when both parties benefit. Under ideal market conditions, this process leads to an efficient allocation of goods without government intervention. 

However, economics has long recognized instances in which markets can fail to lead to an efficient outcome. The long-standing view is that either market power or the nonexistence of markets causes market failures. Market power is present when some individuals or firms are price makers (for example, monopolists) rather than participants in a perfectly competitive environment. Such situations typically lead to the production of a less than efficient quantity of goods. The problem of market power is the purview of industrial organization economics and antitrust policy.1

The nonexistence of markets, or the failure of a robust market to arise, can occur for a number of reasons, such as asymmetric information (when one party in a transaction has information that is not available to another) and public goods (when a good is nonrival and nonexcludable in consumption and thus likely to be undersupplied by the market). Another cause for the nonexistence of markets is externalities, which occur when transactions impose costs or benefits on a third party that are not considered in the market exchange. A classic example is when a factory produces and sells a good to a consumer to their mutual advantage, but the pollution generated by the production of the good has a negative impact on the health of nearby residents. A market for the clean air in the affected area would not emerge if high transaction costs of organizing the pollution victims prevented the parties from negotiating.2 The market system will fail to internalize the health costs imposed by the factory’s operations and lead to inefficiently high production and health consequences. 

For about a century, economists have argued that policymakers should rely, when possible, on market-based principles in designing regulations to address these market failures. For example, in the pollution cases above, a tax on production equal to the marginal external costs could lead producers to internalize the thirdparty costs stemming from production, which would result in an efficient outcome.3 Similarly, establishing a property right for the clean air (for example, through a cap-and-trade program) could also cause producers to internalize the third-party costs in their market decisions, again resulting in an efficient outcome. 

But in recent years, economics has seen a change from the traditional approach of evaluating market failures and in the justifications for government intervention in the economy, with implications for when and how the government should intervene. Recent research has focused on identifying cognitive limitations and psychological biases that lead people to make choices that cause self-harm, thus suggesting another type of market failure that justifies government intervention.4 We refer to these phenomena as behavioral failures in that they often involve departures from the individual rationality assumptions incorporated in economists’ models of consumer choice. 

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