Wednesday, August 26, 2009

On Becoming a Libertarian Paternalist: Designing Better Policies for the Society (Part 1)

A Libertarian Paternalist is someone who believes in Libertarian Paternalism, but since I'm guessing that most people wouldn't even know the definition of Libertarian Paternalism, you can check the definition here. So, why are we discussing this issue?

I have just finished reading a book titled "Nudge," and a very interesting book it is. Made by Richard Thaler and Cass Sunstein (Professors of economics and law at the University of Chicago, respectively) this book introduces the movement of Libertarian Paternalism, a movement that supports governments and private institutions to adopt policies which can maintain or maximize people's free of choice while in the other hand influence those people to improve their life and important decisions, such as wealth, health, and happiness. The basic reasoning is quite logic, people make errors most all the time and in reality, there is no such a neutral design in making a policy, so why don't we maximize the possible choices for the people, design the most possible best options, encourage people to take the best options, but ultimately let them also be free to take their own actions with regard to the choice alternatives?

The book also offers several forms of incentives and methods that can be used by governments and private institutions to improve people's life in accordance with the Libertarian Paternalism movement. For someone who are trying to find how to structure the best policy or regulation for certain issues in this life, I find that this idea is enlightening.

Human = Error?

I have to admit that the idea that common people tend to err on a regular basis is quite disturbing. However, there are too many supporting facts on this issue that would prevent us from declaring the idea to be baseless. See this site for additional insights on human errors, especially with respect to daily economic activities (by the way, Dan Ariely's book, Predictably Irrational, is also highly recommended).

While I believe that men are rational beings, i.e. able to think rationally and make decisions on a reasonable basis, I can't deny the fact that our decisions are subject to various internal and external factors, and these factors may take a dominant position, even more dominant than our own rationality. Let us face it, how many times did we make a decision based on a cool and wise demeanor? I bet that most of us will answer: seldom. In most cases, decisions are being made by our impulsive side, the automatic system in our mind which is very vulnerable to biases and blunders. Not to mention our weak self control, overconfidence, excessive ignorance, and tendency to follow the herd (i.e. going with the trend without too much thought). All of these factors may negatively affect our ability to make a better choice in our life.

See some of these interesting examples:

1. On Procrastinating
Procrastinating is always be a big problem for most of the people. You might be familiar with these statements: "I'll save money as soon as possible," "damn, I'm getting fat, I should exercise tomorrow," or "well what do you know, the deadline for the paper is still three months, I guess I'll take a break for a week and finish it later." Yes, most of us procrastinate, including myself. But how come? Aren't people aware on the danger of being obese, or retiring from a job without any saving? Then why people still procrastinate? Is it due to irrationality or an overconfidence or simply an inability to grasp the actual risks associated with our actions?

Have you ever think why some governments issue mandatory pension plan for their citizen, where the citizen is forced to put some of their salaries to their pension account? I dare to say that this is one of the reasons.

Having a mandatory pension plan is a positive nudge, although of course how we should structure such plan to reach the maximum results is another case to be discussed. By having a mandatory pension plan which automatically enrolls worker to some form of pension funds, the government may save people from being poor after their retirement due to low saving. True that the pension plan can go bust, but the risk is smaller than letting people not having any pension plan.

2. On the Ownership Bias
Several researches made by Thaler & Sunstein and Dan Ariely reveal that people are having difficulties in determining the value of certain goods due to the ownership problem. Those who possess an asset tend to value their asset higher than those who don't posses such asset, and the discrepancy of the value can be very, very huge. In one of Thaler & Sunstein experiments, participants are being given a mug or a chocolate bar having the same price. Half got the mug and the other half got the chocolate. Interestingly, when they are being asked to trade their mug with the chocolate and vice versa, only 10% of the participants are willing to trade. Why?

In another case, Dan Ariely made an experiment using college students where some of them successfully obtained a ticket for a really famous university basket ball final competition and the others failed to do so. These tickets are very hard to obtain, and most students must spend their nights in tents just to have an opportunity to get lotteries for getting the tickets. Yes, lotteries! Even after spending two days in tent, they still need to push their luck to get those tickets. However, despite the difficulties in getting those tickets, there were many students who participated in getting the tickets.

After the tickets distribution, Dan contacted students from both sides to find out how much they value their tickets, and he found a very amazing result. In general, those who failed to obtain such tickets were only willing to pay max US$170 for buying one ticket, whereas those who obtained such tickets were only willing to sell their ticket for a minimum of US$2,400 per ticket. This is amazing, especially when we considering the fact that before the distribution of the tickets, almost all students were very eager to obtain the ticket.

So, what is the effect of this ownership bias? Because people tend to value their owned goods higher and hates losses for whatever they cost, they would be more likely stick with their current holdings, even when such condition is not always better. In a more complex way, the ownership bias can be used to lure consumer toward what Dan Ariely calls the "virtual ownership," i.e. making people think that they have ownership over an asset in order to increase the opportunity of such people to purchase the assets with a higher value. One example is where your cable TV operator provide you with a "gold package" limited trial period with a discount. after certain period of having a standard package. When you try it for the first time, most of you would probably think that if you don't like it, you can always back to the standard package, or say, downgrade it a little to the "silver package." But in reality, most people tend to just stay with the gold package after the limited period expire even though the price has become more expensive. Why? Because people hate to lose the facility that they have obtained previously.

Ask yourself, it's hard to downgrade your quality of life right? As long as you have sufficient funds, you would most likely try to maintain your quality of life, even if it is getting more and more expensive, rather than to cut some expenses and save more money from the cutting. So don't be confused when some people claim that the richer you are, the bigger your expenses will be.

3. On Free Items Bias
Other experiment made by Dan Ariely shows our fragile way of thought when we are dealing with free items. The experiment was done in a halloween day where Dan gave chocolates and candies to kids wearing costumes. At first, he would give these kids three small Hershey candies and then give them 2 options, i.e. (i) if they are willing to give him back one candy, they'll get a small Snickers chocolate bar; or (ii) if they are willing to give him back two candies, they'll get a big Snickers chocolate bar (twice the size of the small Snickers). The Hershey candy itself only worth 1/10 of the big Snickers.

In the first experiment, almost all children successfully pick option No. 2. However, in the second stage of the experiment, Dan change the condition, i.e. (i) they'll get a small Snickers chocolate bar for free without having to give any of their Hershey candy; or (ii) if they are willing to give him back two candies, they'll get a big Snickers chocolate bar. Interestingly, now most children take the first option which, if viewed by a rational man, should be considered as a very bad choice. Again, how come? It is also interesting that Dan repeated a similar test to other people, including college students, only to find similar results! Seems that there isn't much development in human behavior when we're dealing with this kind of issue as children and adults encounter similar results.

It doesn't take a genius to understand that the free item bias have been used many times for business marketing purposes. Try to think of some, and you'll soon realize it. Next time, when you go to a sale, try to compare, would it be better to have a 50% discount or a buy one get one benefit? Or, what is better, having a 30% discount or a buy 2 get 1 benefit? When you're getting this question, you will start to think carefully in determining the best option. But, if people are not thinking it through, I dare to say that most people will take the buy one get one or buy two get one benefit.

Rational Imperfect Beings and The Need to Design Better Policy
We have discussed above some examples of the great ability of men in making errors in daily life. But let us don't forget that men is able to think rationally, men respond to incentives and information. We might be imperfect beings, but it doesn't mean that we are completely irrational. If the government or private institutions can design a better policy which will encourage people to really think deeply about their life and decisions, wouldn't that be very good?

What are the criteria for designing a good policy? You'll have to wait the second part of my post. So please be patient on that :).

2 comments:

Jhordy Kashoogie Wednesday, August 26, 2009 8:56:00 PM  

is it kind of book review? good analysis happening in our daily life!

Pramudya A. Oktavinanda Thursday, August 27, 2009 10:18:00 AM  

A little bit, but the purpose is not to make a book review though, hahaha. I'm interested with their idea, and I believe it would be good to share it in this blog. Some further analysis will be made in the next part.

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