Universitat Pompeu Fabra and BGSE Emeritus Research Professor Robin M. Hogarth shares some thoughts in the light of Prof. Thaler’s award of the Nobel Prize in economics.
What would you deem to be the most significant contributions of Prof. Thaler?
Prof. Hogarth: “I’m very glad that Thaler got the Nobel Prize, because it’s a recognition that the field of behavioral economics has to be taken seriously. He has made the field more popular and two of his books are quite interesting. Even though from an academic point of view ‘Nudge’ may not be so strong, in both ‘Nudge’ and ‘Misbehaving’ Thaler has done a very good job in explaining things and making behavioral economics accessible to the wider public. ‘Nudge’ has spurred the creation of nudge initiatives in the UK and the US.”
Prof. Thaler has greatly contributed in popularizing behavioral economics and manifesting the insight it can offer in practice and policy, especially though the use of nudges bringing nudge theory to prominence. However, as is most times the case with influential research, Prof. Thaler’s work has also been a matter of controversy, as criticism of what is called ‘libertarian paternalism’ has developed. Concerns have been raised both in regards to freedom of choice (e.g. Mitchell, 2005; Veetil, 2011) and the efficiency or optimality of paternalistic policies (e.g. Rachlinski, 2003; Mitchell, 2005; Glaeser, 2006).
How do you think concerns regarding the use of nudges can be alleviated? Do you think there needs to be any form of regulation on it?
Prof. Hogarth: “Thaler and his co-authors have supported nudge coining the term ‘libertarian paternalism’. Although I don’t think the term makes much sense, I don’t see what is wrong with governments saying that some things are better for people than others; advertisers do it all the time.
In some EU countries there is a total rejection of organ donation after death, while in others almost total acceptance and the reason is the difference in the default option on the driving license among countries. I don’t see why this is wrong; since a default has to be chosen, why not choose the one that is on average better for everybody? Provided that people can still go against the default, if they want to. Governments should be able to use as much social science knowledge as they want. As long as there is “good knowledge”, why should we ignore it? Whether it comes from sociology, psychology, anthropology, economics or whatever, we should use it, as long as it is good for the society.
I don’t think there is any need for regulation of nudge. One should not regulate how advertisers advertise the products, as long as they say the truth. Similarly, governments or agencies should be allowed to design choice; they just need to be honest and clear about it.”
Are there any other thoughts you would like to share in the light of this year’s awarding of the Nobel Prize in Economics?
Prof. Hogarth: “Another interesting aspect of Thaler’s work is that it has managed to make an impact without being heavily mathematical. The other point I would like to make is that Thaler owes a tremendous debt to Tversky and Kahneman. Prospect theory provided a framework for explaining things Thaler thought of.”
We kindly thank Prof. Hogarth for sharing these thoughts with us.
Glaeser, E. L. (2006). Paternalism and Psychology. The University of Chicago Law Review, 73(1):133-156
Mitchell, G. (2005). Libertarian Paternalism Is an Oxymoron. Northwestern University Law Review, 99(3):1245-1277.
Rachlinski, Jeffrey J. (2003). The Uncertain Psychological Case for Paternalism. Northwestern University Law Review, 93(3):1165-1225.
Veetil, V.P. (2011). Libertarian paternalism is an oxymoron: an essay in defence of liberty. European Journal of Law and Economics, 31: 321-334.
As any child promised a weekly allowance in return for chore completion can tell you: details matter. When does the trash need to be taken out? What counts as a completely made bed? What happens if someone else makes a mess after that area has been cleaned? The parent wants the chores completed well and timely while the child wants to achieve sufficiency for her weekly candy money. All of these questions that immediately race through the mind of our young adolescent form, little to her knowledge, the basics of contract theory.
These frictions between parent and child, the insurer and the insured, the employer and the employee, and almost any professional relationship between two or more agents, provide the research area of the winners of the 2016 Nobel Prize in economic sciences. Doctors Oliver Hart and Bengt Holmström, both of whom are current members of the BGSE Scientific Council, were awarded the prize for their work focusing on the trade-offs in setting contract terms earlier this week.
The central question plaguing contracts is not what specific form they should take, as there seem to be an infinite number of qualifications even a simple chore contract might inspire, but rather how to regulate the behavior of the agents involved. Applying our example to the case of the firm and its workers, it is clear the firm desires excellent work from the employee, and the employee seeks to know exactly what constitutes the work needed to earn the incentive.
Dr. Holmström’s research on performance-based pay of management and executives directly considers this. His findings suggest pay should be tethered to measures such as company share performance relative to that of direct competitors as opposed to the more commonplace linking to share price alone. Further, his analysis of the insurance market sought to bridge the gap between insurance providers and their clients. Despite the more optimal state of the individuals purchasing full insurance, co-payments still exist. This is because insurers are seeking to disincentivize costly, unnecessary doctor trips. In essence: how can the parent avoid being taken advantage of and how much should our young teenager be paid for her household work?
The work of Dr. Hart attempts to resolve the infinite questions regarding how our teenager can warrant the weekly allowance or how workers will earn their salary. Rather than laboriously delineate every potential scenario a worker may face and how they should respond, Dr. Hart would suggest decision rights be pre-determined amongst agents. This would allow unilateral decisions through a pre-agreed framework to be made when frictions arise. Additionally, the granting of ownership rights, contends Dr. Hart, greatly alters agent behavior. The ice-cream shop manager granted an ownership stake is ostensibly more motivated to work hard. On the other hand, cutting costs by purchasing lower quality ice-cream ingredients might accomplish the same goal at the expense of the shop’s reputation. The important takeaway from the research is that how the rights of ownership and decision-making are divided greatly affects the behavior of actors.
The duo may not have completely quieted all the concerns of the parent or child in the chore contract (or in any of the infinitely many contracts that span our daily lives). However, they have provided a framework to better understand relationships between the agents represented in these little documents so fundamental to society.
The main idea is to show a graphical representation about the scientific publication patterns that have adopted the winners of the Economic Sciences Prize given by the Nobel Foundation (officially, this recognition is known as the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel; colloquially, it is known as the Nobel laureate in economics).
Nobel Laureate Roger Myerson presented his latest paper, ‘Local Agency Costs of Political Centralization’ to the Barcelona GSE community on the 3rd of June.
The central focus of the paper is to examine how efficient the widely accepted notion of Political Centralisation is.
Some existing literature already argues that political decentralization and community empowerment may be the key to successful development. They show how autonomous local governments can reduce entry barriers in national politics. Creating the space for success on a smaller scale can lead to them becoming strong candidates for higher office. The decentralization of power also gives local leaders a stake in nation building.
Others argue that one centralized government could also have the same effects by applying differentiated policies accounting for regional differences.
The need for targeted policies for differing dynamics in different regions is clear but the way to achieve this is still being explored. Myerson comes in with this paper is to show that in order to achieve efficient local public investment there needs to be accountability which is best achieved with decentralization of power.
The mechanism he uses to analyze this issue is a model of moral hazard in local public services in which an efficient solution is only feasible when officials are held accountable to local voters.
Political Decentralization can lead to Accountability
If the quality of the local public services can only be observed by the local residents, then unless the residents have power over the officials’ career, they will not be accountable.
If the local residents do not have the power to dismiss the officials, their careers would depend more on political relationships than on effectively managing local public services. This would have a roundabout effect on development as without good public services, private investments would be scarce since the success of these investments would depend on the quality of these public services.
In his talk he expounded on the following example to illustrate his findings. In a remote town, if we imagine each resident invests to start an enterprise whose probability of success would depend on the amount spent on public services in the town. The only observable evidence that the official spent the money on public services would be the number of successes among the residents’ enterprises.
This budget is managed by the local official, who could divert any part to his personal consumption. What Myerson shows is that there is a premium that can be paid to the official in addition to his salary that would incentivize the official to stay. This would make up the moral hazard rents and allow the efficient amount of investment to be spent.
Myerson shows that for a given budget if the official is paid ‘p’ if a specified fraction of residents report success then the renewal thresholds and official salaries can be set as functions of the local population ‘n’ that would result in the efficient budget and induced public investment levels.
Distrust and Instability
However if there were distrust, the voters would rather replace the incumbent if they expect the funds to be stolen in the future. In this case, public investment and residents’ benefits would be a decreasing function of the political instability parameter ‘q’. However as long as the utility from the induced public investment for the given level of instability is positive, residents can still benefit.
Autocracy – Rulers Incentive
In an autocracy the national ruler can commit to allow the town to elect an autonomous local government in exchange for a tax the residents would pay until their utility is maximized.
Moral hazard rents would be paid by candidates in terms of cash or political support. The autocracy could offer these offices as rewards for support and help them ward off challengers in this way.
If the national ruler could credibly commit to allow an autonomous local government after picking the first incumbent local official, the ruler could gain fiscal and political benefits per resident. But for this to happen, the ruler must make a credible commitment to the division of power constitutionally which would be against his interests ex-post.
With local accountability then the ruler would not be able to use the offices as rewards as this would make him vulnerable to voters distrust.
If successful they could be serious contenders for national office competing against him. This may be politically too costly for the incumbent national leader.
Separation of Information from Influence in an Autocracy
Key supporters are important for the success of any leader. A leader can get more support when key supporters monitor how he treats others so not rewarding one would cause distrust in all. If successful, competitors cannot recruit supporters without constraints.
Since an autocratic ruler is only accountable to these courtiers, they must deter wrongful dismissals as he can resell the vacant offices with moral hazard rents.
Courtiers can impose political costs on the ruler but these costs cannot depend on information that the ruler would be able to manipulate.
Courtiers could impose a penalty on the ruler depending on the set of dismissed officials. They should choose this penalty such that the dismissal set is a small fraction of all offices. If the net service value the ruler would get from replacing the official would equal his penalty for dismissal, the ruler would pick the dismissal set based on information on public services. However on the other hand, he might choose to dismiss those with the best services as they may prove to be strong contenders and rivals.
Under democracies also, political leaders need the reputation of rewarding patronage to motivate supporters. Under democracy, local autonomy threatens to increase competitive entry into national politics against the interest of national officials. One example of this given was Pakistan. National democratic competition also raises the political risk for the retention of appointees.
However if Local Accountability leads to better Public Services could Democracy induce leaders to promise it?
An analysis shows that with sequential bids the challenger can win by offering marginally more in most districts and zero where the incumbent spends the most. Contrary to the optimal socially, this will lead to small offers everywhere.
Endogenous Decentralization in a Unitary Democracy
However if public budgets are fixed as in most cases, then candidates can compete based on promises of accountability of the local officials. An alternative for this would be for the candidate to sell the office for a political contribution and then spend this money obtained on the campaign. This would win over the uninformed voters while the informed would vote for the best promise. This result thus depends on the proportion of the population that is informed.
Inefficient Centralization in a Unitary Democracy
Citing the example of Ukraine, Myerson also warned of the possibility of politically neglected regions being dangerous for a nations territorial integrity if it facilitated the opportunity for disaffected regions to secede. In an equilibrium of a 2-candidate election for national leadership of a unitary state, each candidate would naturally maintain inefficient centralized management of local public services in a fraction of all districts.
The key points were that moral hazard in local public investments can be efficiently managed with local accountability. When the public services can only be observed by local residents, officials can only be held accountable if their careers depend on the resident’s approval. Political decentralization would guarantee such local power.
However if the leader can resell offices then he would not a neutral judge of the local public services. In the specific case of a centralized autocracy, dismissal must be approved by the national elite and residents cannot communicate their complaints to them, so without a guarantee of local political rights there can be no credible commitment to sustain efficient local investments by the autocratic national government.
The last couple of months we have been breathing, eating, sleeping and dreaming of Economics. Very quickly words and phrases such as optimization, consistency, “my function of studying has a negative first derivation since monday”, “there is no Nash equilibrium in our restaurant choices” entered our every day communication. Most popular Google searches and old bookmarks were replaced by blogs about econometrics and game theory, and reading the news came down to skipping to the Economics and Finance section. There was nothing to complain about, as Bukowski put it “if you are going to try, go all the way”, and there was no other way to do a Masters in Economics. But when it came down to economic models trying to explain love, I was not going to give in so easily.
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