Mechanisms never come alone04.04.2018
In the new issue of the Journal of Economic Perspectives there is a paper that overviews and evaluates the literature that aims at explaining why so many people seem to leave money on the table. Well, as the famous joke about economists tells us, they might be hyperrational and just think that somebody would have already taken the money anyway, so it cannot exist and is a mere illusion. But that is not what behavioural economists think: They look for causes why people seem to commit so many mistakes, for example when buying suboptimal insurance contracts or when preferring branded medicine over generics even if the ingredients are fully transparent, and the information about the equivalence of alternatives is widely available.
The paper attracted my attention because it uses the concept of ‘mechanism’ extensively, even coining the word ‘mechanism policy’, which means a public policy intervention that would directly intervene into the mechanisms that generate these mistakes. Evidently, this would presuppose that we know the mechanisms. Here, the paper is interesting for the methodologists, since the authors point out that most papers are not methodologically sound. Most importantly, papers do not directly compare different mechanisms that might be possibly relevant, and they even do not track the precise workings of the alleged mechanisms. Basically, the authors distinguish between two types of explanations, one is referring to frictions, the other to mental gaps. Frictions is a neoclassical explanation which mainly remains compatible with rationality, as people may rationally consider search costs and other costs of information processing. Mental gaps refer to cognitive failures such as misrepresenting the decision situation and the alternatives. However, the authors also mention that there are many other possible mechanisms, such as those which are discussed in the literature about self-deceit.
In other words, we have an example where the methodological principles of mechanistic explanations can be very helpful to assess the relevance of existing research, especially when considering consequences for policies. There are deep philosophical issues here. If we follow the authors in distinguishing between ‘allocation policies’ and ‘mechanism policies’, a simple argument in favour of the former is that the external observer is fully informed about the welfare losses, and so canand even should intervene in an authoritative way. For example, if it is scientifically valid that branded and generic medicine is exactly equivalent, why shouldn’t the government issue a regulation that would at least order doctors to prescribe generics only? In comparison, a mechanism policy might only give the information, if it is just search costs that are the problem. But once we investigate into mechanisms, the problem arises whether the perspective of the external scientific observer is really the same as that of the people concerned.
This leads us to considering the principled question what the functions of certain mechanisms really are. Let me give a straightforward example. In a paper on consumption patterns in India, the authors showed that poor people spend more on cigarettes and alcohol than middle class people, in terms of relative share in household expenditures. The explanation seems straightforward: Poor people are less well informed about the consequences than better educated people. But this is wrong. We need to ask, what is the function of buying cigarettes and alcohol? The authors of the study argue that the function is conspicuous consumption, that is, showing off relative status in their peer group. In comparison, in middle class groups status is demonstrated in other ways, such as educational degrees, a car, and so on. Therefore, people spend less on alcohol and cigarettes. In that view, there is no difference between the two groups in terms of information and cognitive maps, the underlying mechanism is the same, status consumption. What is consuming branded medicine has the same function?
I think that in analysing mechanisms, two fundamental issues always need to be considered.
First, what is the function of a mechanism that might apply across many different situations beyond the one that is considered in identifying alleged failures of rationality? In evolutionary terms, mechanisms emerged via a selection process that refers mechanisms to various possible environments, and alleged failures and irrationalities might not result from internal deficiencies of the decision process, but from a mismatch between situation and mechanism. For example, if consuming branded medicine is status consumption, is this adequate, given the social context? Obviously, this is difficult to decide in terms of policy design. Perhaps people might stick to their decision even if they are explicitly told about the true costs. Why? Because the costs are what communicates the status. And this is true for many other situations, too.
Second, how do mechanisms interact, or, what are the trade-offs between different mechanisms? Considering this in evolutionary terms, again, we need to consider that behaviour is a complex and integrative phenomenon; optimizing single mechanisms would have always come along with costs, in terms of investing less in other mechanisms. One problem with the literature overviewed in the JEP paper is that it mostly focuses on single situations of choice. But the mechanism generating the behaviour might be functional in other contexts; or, optimizing it further might impact negatively on other mechanisms, and so on. For example, 25 years ago I argued that loss aversion might not be a cognitive failure but might have been positively selected as it triggers the so-called ‘strategy of bourgeois’ in social conflicts about territories and resources. Even if it might entail efficiency losses in specific situations of choice, the total outcome across all situations might be positive: The efficiency losses in one situation are the price to be paid for behaving optimal in another situation.
In sum, if we adopt an evolutionary perspective, a major challenge is that we implicitly fall in the trap of doing what economists call ‘partial equilibrium analysis’. Mechanisms never come alone.
Handel, Benjamin, and Joshua Schwartzstein. 2018. ‘Frictions or Mental Gaps: What’s Behind the Information We (Don’t) Use and When Do We Care?’ Journal of Economic Perspectives, 32 (1): 155-78.
Herrmann-Pillath, Carsten (1994). Evolutionary Rationality, „Homo Economicus“ and the Foundations of Social Order, Journal of Social and Evolutionary Systems, Vol. 17, 1, 41-70. http://ssrn.com/abstract=950590.
Moav, O. and Z. Neeman (2012), ‘Saving Rates and Poverty: The Role of Conspicuous Consumption and Human Capital’, Economic Journal, 122, 933–956.