Bounded Rationality_ Individual Choice and Paternalism - Slide 1.ppt

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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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