How to apply behavioral economics to policy analysis

Earlier this year, the National Academies of Science, Engineering, and Medicine released a new report detailing how insights from behavioral economics can be applied to a policy context. 

Behavioral economics is a sub-branch of economics that focuses on understanding why humans make the choices they do, specifically in situations where classical economic models fail. Sitting at the intersection of classical economics and psychology, behavioral economics is especially suited for quantitatively measuring seemingly irrational actions.

One of the key takeaways from the report is five behavioral principles that the National Academies identified as having a strong influence on people’s decision making. Understanding these principles is key to designing good policy options. 

Limited Attention and Cognition

Humans only have a limited ability to process information. This is a problem for classical economic models that often assume that all parties have perfect information and are perfectly rational. 

For policy analysts, this means we should be careful when using research that relies on individuals' attention and cognition, as the results might not hold in a new context. Policymakers should attempt to focus on policies that are as simple as possible and don’t require a great deal of understanding in order to be effective. 

One example of this is the market for health insurance plans. In theory, it might seem optimal to have a massive amount of options so everyone can tailor their plan to meet their specific health needs. But often consumers do not have the time or energy to fully understand different plans and they end up with sub-optimal outcomes.

Inaccurate Beliefs

People make mistakes. We might mistake spurious correlations as causal trends, misread a question on a survey, or we might over/underestimate the severity of a problem. This is often the result of our limited attention and cognition, but the result is that sometimes it is worthwhile for policies to come with education in order to make sure everyone is on the same page.

For example, some people may overestimate the probability of dying in a terrorist attack and underestimate the probability of dying in a car crash. This can lead to a market failure where people were spending more resources than they need to prevent terrorist attacks and less resources preventing car crashes. 

Present Bias

People tend to focus on what is in front of them. It is much harder to fully understand the effects of a policy if it takes years for them to come into place. In policy analysis, we partially represent people’s preference for the short term by discounting future benefits. 

Still, discounting relies on the assumption that there is some uncertainty about the future that we need to price into our estimates. Present bias implies that people tend to prefer short term rewards beyond what would be optimal given their preference for risk. 

It is important that policymakers take a step back and see the bigger picture. Some policies like early childhood education don’t have payoffs until generations later, but their impacts can be so massive that they should still be prioritized. 

Reference Dependence and Framing

Humans tend to make risk decisions based on a particular reference point rather than evaluating all possible options. For example, a policymaker might believe the best way to improve test scores in a school might be to increase the number of teachers, while missing a more creative and effective solution like ensuring students have enough food to eat outside of school hours. 

When discussing policy options, both analysts and policymakers need to be careful that they are exploring all possible alternatives. 

Social Preferences and Social Norms

People tend to make decisions that conform with social norms. Asking people to break social norms is very difficult, and would presumably require more effort than asking people to conform. 

From a policy perspective, this suggests that we should look for policies that are designed in such a way that they either align with social norms, or create new norms. For example, if we want to encourage people to recycle, then it would probably be more effective to drop off bins at every house as opposed to making them free to those who ask. 

Policymakers and analysts need to make sure that they are considering behavioral economics each time they approach an issue. Doing so will help us design more effective and efficient policies, as well as making it more likely that people will respond to policies in a predictable way.