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Bounded Rationality, Individual Choice and Paternalism: Social Security Reform as an Example by Eytan Sheshinski The Hebrew University of Jerusalem and Princeton University Presentation at the fall meeting of the American Philosophical Society, November 14, 2003 The Benefits of Choice • Economists view choice as something that one can‟t have too much of, like clean air and beauty. • Choice supports differentiated tastes and needs and generates competition among providers, leading to lower prices (higher quality). For the benefits of competition to be realized consumers must be reasonably well informed about price and quality. The message of the new „Behavioral Economics‟ is: in many domains people lack stable, well-ordered preferences. What they choose is a product of framing effects, starting points and default rules, leaving the very meaning of preferences unclear(Thaler and Sunstein,2003). The Rationality of Choices “People make choices that are in their best interest, certainly better than choices made by third parties”. Counter arguments backed by experimental and empirical research(Thaler and Sunstein,2003): people do not exhibit rational expectations; fail to make forecasts consistent with Bayes‟ rule; use heuristics that lead them to make systematic blunders; exhibit preference reversal; suffer from problems of self-control. [Rates of obesity in the U.S. exceed 20 percent and over 60 percent are either obese or overweight. Obesity leads to serious health risks, frequently leading to premature death. Experts agree that these reflect problems of self-control and short sightedness as well as ignorance]. • Framing effects. Concerning a risky medical procedure, when people are told “of those who have this procedure, 90 percent are alive after five years” they are far more likely to agree to the procedure than when they are told that “of those who have this procedure, 10 percent are dead after five years” [Tversky-Kahneman]. • Starting-Point Effect. Most 401(K) plans use an opt-in design, employees filling an enrollment form to join. The alternative is automatic enrollment, employees receiving the same information, but are told that they may register to opt-out. Moving from the former to the latter method, enrollments were found to jump from 49% to 86% [Madrian and Shea, 2003] . Should the adoption of automatic enrollment be considered justifiable paternalism? Preferences seem to depend on domain and context. Choosing a default may be avoided if employees are required to make a choice („coerced choosing‟). Should people have the freedom to procrastinate? Another study illustrates the attraction and importance of default options [Johnson et-al, 1993] . Buyers of auto insurance in New Jersey and Pennsylvania were given a choice whether to pay lower rates in exchange for reduced rights to sue for pain and suffering. In Pennsylvania, the default was the full right to sue, with a rebate for accepting reduced rights. In New Jersey, the default was a limited right to sue with a surcharge to get the full rights. In both states, about 75-80 percent of drivers took the default option. Presumably, most people were “deciding not to decide”. Another important example: the appropriate default rule for organ donations (Johnson and Goldstein,2004). In many nations – Austria, Belgium, Denmark, Finland, France, Italy, Luxemburg, Norway, Singapore, Slovenia and Spain – people are presumed to consent to allow their organs to be used after death for the benefit of others, but they are permitted to rebut (on their drivers licenses) this presumption. In the U.S. (and Israel), in contrast, those who want their organs to be available for others must affirmatively validate their choice (also on their drivers licenses). In the „presumed consent‟ countries over 90 percent of the people make their organs available for donation, while in the U.S. it is below 20 percent. We predict that the European default rule if applied in the U.S. would produce European-Style donation rates. The default rule for organ donation does not fit the usual definition of paternalism since it concerns the welfare of third parties, not of choosers. With respect to behavior, however, the analysis is similar. Which default rule better promoters welfare? In this case, coerced choice may reveal the „true‟ preference. • Is Paternalism inevitable? In many situations, some organization or agent must make a choice that will affect the preferences and behavior of others. Peoples‟ preferences often do not predate the choices made by planners [cafeteria example]. Some libertarians will accept efforts by private firms, but not by the government, to steer people‟s choices because market pressures are thought to impose protection against objectionable steering. Trade off Contrast: Choice dependence on ‘context’ Contrast effects are ambiguous in perception and judgment. A circle appears large when surrounded by small circles and vice-versa. Simonson and Tversky (1992) have shown that the contrast effect applies not only to single attributes but also to the trade-off between attributes. In an experiment, they examined the trade-off between quality and price. When subjects were given background information – (background A) about expensive (pricewise) exchange rates between computer memory and prices they tend to choose larger computer memories compared to subjects who are given background information about cheap exchange rates between these attributes. The Importance of Bounded Rationality and Choice in Social Security (SS) Reform Can individuals be considered as „rational‟ when it comes to long-term savings for retirement? The „Reasonable Person‟ approach: Consider an individual who works and saves for 30 years (age 35-64) and then retires for 15 years. When working, he/she has a constant income flow, Y. With a constant savings rate s and interest compounded continuously at rate i, wealth at age t, Wt , is: sY (t -35)i Wt = (e - 1) i The constant annuity that can be financed for 15 years out of W65 is 15i e A = iW65 (e15i - 1) Setting the replacement rate, A , at ⅔ , implies the (1 - s ) y following numbers: Interest rate 0 .01 .02 .03 .04 Savings rate .25 .21 .17 .14 .12 Wealth/income at 65 6.5 6.0 5.6 5.3 4.9 With an income growth rate of 2%, constant retirement benefits after retirement and a 2/3 replacement rate for consumption at age 60, the numbers are not much different: Interest rate .02 .03 .04 Savings rate .21 .17 .17 Wealth/income at 65 5.2 4.9 4.6 Now, let‟s look at the actual data derived from the Social Security Data base: Percent of married Men 58 – 63, in 1969, with No Pension Coverage (US): Wealth-Earning Ratios Earnings Level ≤1 ≤2 Under 2500 74.7 76.4 2500 - 5000 26.4 29.6 5000 – 7500 14.6 30.0 7500 – 10,000 13.1 26.8 10,000 – 12,500 7.7 17.6 12,500 – 15,000 - 11.8 15,000 – 25,000 2.7 13.7 25,000 and up 2.6 13.1 Summary: 10 – 15 percent of the population have a wealth-earnings ratio below one and 30 percent have a ratio below 2. Other data exhibits even higher percentages [Diamond, 1977]. • Under the current SS system, individuals have almost no choice except when to start claiming benefits once eligible. * 5/9 of one percent higher benefits for each month delay in retirement (about 6 percent annually). • Reform proposals are to shift part of (mandatory) SS contributions to personal accounts which will be invested in the market. The cumulative returns will determine the level of retirement benefits („Defined Contribution‟ system, in contrast to the current „Defined Benefit‟ system). What trade-offs will people be offered and how might they respond? Investment Choices • One or more accounts (programs) allowed? • Division between stock and bonds (in TIAA-CREF, specific investments are made by the fund)? • Choice between single or joint accounts (dividing family income between spouses)? • Possibility to combine retirement with other insurance, e.g. Life Insurance (general issue of survivors‟ benefits)? • Should withdrawals before retirement for specific purposes (such as unemployment insurance, recently suggested by Stiglitz) be allowed? • Purchase of deferred annuities be available (when, how much, type of annuities)? • Choice of fee structure (front loading, management fees or combination of formulas)? • Add-On options • Early eligibility – partial retirement and delayed retirement credit Annuitization Choice • How many types of annuities (x-year certain, single-joint etc.)? • Indexation choice (nominal, CPI, Wages) • Mandatory full or partial annuitization (programmed withdrawals), maintaining a minimum replacement rate? • Who will be licensed issuers of annuities and providers of benefits (SS, pension or insurance firms)? • Will there be choice between different benefit profiles over time? How Much Choice: Modelling Bounded Rationality “It is easy to talk about bounded-rationality but it is difficult to model it in a disciplined way” (Mirrlees). • The Multinomial Logit Model Probabilistic choice among a finite number of discrete alternatives. Choice probabilities are based on Luce‟s “Choice Axiom” (a „path-independence‟ axiom). Probabilities depend on the domain (choice alternatives). Luce‟s Theorem states, roughly, the following. Suppose individuals are identified by a preference parameter θ ≥ 0 (attitude to work, health,…). Facing n alternatives, the probability that individual θ chooses alternative i, Pi(θ), is given by qui (q ) e Pi (q ) = n e qu j (q ) j =1 where ui, i = 1, 2,…, n, are scalar functions („utility‟). The parameter, q > 0, exhibits the precision of choice: when q = 0 all alternatives have equal chance, 1 , when q → each individual chooses n the most preferred alternative: argmax [u1, u2,…un]. There is an aggregate distribution of individual types (θ). The government knows this distribution but cannot dictate individuals‟ choice. Individuals‟ welfare is measured by expected-utility. An increase (decrease) in the domain (number of alternatives) exacerbates (reduces) the errors made by individuals but improves (worsens) the welfare of those who prefer the added (eliminated) alternatives. Suppose that social welfare is utilitarian, i.e. it positively depends on the sum of individuals‟ welfare. Theorem: (a) When q is „large‟ (for all individuals) then the full set of alternatives is always optimal. (b) When q is „small‟, it is always optimal to entirely eliminate individual choice [the „shrinking‟ of the choice-set is monotone in q]. Calculations indicate that it is desirable to eliminate individual choice at surprisingly low levels of errors. Example: [Two alternatives (1, 2). Two homogeneous groups of individuals: group 1 (2) prefers alternative 1 (2). The critical statistical type I and type II errors that lead to elimination of one of the two alternatives are extremely small]. Closing Remarks: Objections to ‘Libertarian Paternalism’ Although the arguments for libertarian paternalism seem compelling ( this term, and the following discussion, was put forward by Thaler and Sunstein(2003)), we wish, in closing, to respond to certain concerns: • This is a start of a „Slippery-slope‟. Once one grants that default rules („cafeteria lines‟) should be designed paternalistically, there will be an onslaught of intrusive paternalistic rules. Three responses: (1) in many cases there is no alternative to paternalism (in the weak sense); (2) opt-out rights can limit the steepness of the slope; (3) if planners, bureaucrats and managers suffer from self-control problems, so do other people! • Planners are often unable to make sensible choices, because they lack the incentives created by market pressures. • An argument in the opposite direction: based on evidence of bounded rationality and self-control problems in many domains, people should not be given the freedom of choice because they choose poorly. These complex philosophical issues of value and fact we have to leave open in this talk.
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