How the market gives us what we want – even if we are irrational

1. How the market gives us what we want – even if we are irrational British Academy Keynes Lecture 2010: Robert Sugden

2. As this is the Keynes Lecture in Economics, named in honour of one of the greatest economists of the 20th century, I ought to start with some link between my topic and the work of John Maynard Keynes. This might seem difficult, because my lecture is a defence of the market, rather in the tradition of Friedrich von Hayek. Hayek is usually seen as the patron saint of pro-market economics, and Keynes the patron saint of market regulation and planning. But … 2

3. Keynes to Hayek in 1944, after reading The Road to Serfdom: ‘We all have the greatest reason to be grateful to you for saying so well what needs so much to be said... Morally and philosophically I find myself in agreement with virtually the whole of it; and not only in agreement, but in a deeply moved agreement.’ 3

4. Keynes over lunch at the Bank of England, 10 days before death in 1946: ‘I find myself more and more relying for a solution of our problems on the invisible hand which I tried to eject from economic thinking twenty years ago’. 4

5. The invisible hand … by directing that industry in such a manner as may be of the greatest value, [the merchant] intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for society that is was no part of it. … Adam Smith, Wealth of Nations, 1776, p. 456. Or more generally: the market is a spontaneous order with unintended consequences that are broadly beneficial, and that may be more beneficial than those that can be produced by deliberate planning. 5

6. I don’t want to pretend that Keynes has been misrepresented, or that in the last few days of his life he had a conversion experience. But these quotations tell us something about how deeply the idea of the invisible hand is embedded in the professional thinking of economists. This has been a core idea of economics for over two hundred years, and one that non-economists continue to find counter-intuitive. Economists now find Smith’s insight so obvious that they are often more excited about investigating exceptions (as Keynes did in his macroeconomics), but that doesn’t make the insight less true or important. In this lecture, I want to defend the idea of the invisible hand against a new challenge, from behavioural welfare economics. 6

7. Behavioural economics tries to explain economic behaviour by using research methods and theoretical ideas adapted from psychology. I’ve followed this approach since the early 1980s. So, I see myself as a behavioural economist. Until recently, behavioural economics was an almost wholly descriptive enterprise – discovering patterns in individual and small-group behaviour which are inconsistent with traditional rational-choice theories, but which psychology can explain. However, its findings pose severe problems for conventional forms of normative or welfare economics (i.e. the analysis of recommendations about how the economy should be organised, what economic policies governments should follow, etc.) Recently, behavioural economists have started to think about these problems. Hence, proposals for ‘behavioural welfare economics’. 7

8. The problem of reconciling normative and behavioural economics From the early 20th century, the dominant form of economics has been neoclassical. A fundamental assumption of neoclassical theory is that individuals have coherent preferences over all relevant economic outcomes, and act according to those preferences (= ‘maximise utility’). ‘Coherent’ preferences are: -- stable (i.e. not subject to random or arbitrary variation); -- context-independent (i.e. not affected by arbitrary changes of ‘framing’ of decision problems); -- internally consistent (i.e. satisfying ‘rationality’ principles such as transitivity). Neoclassical welfare economics uses the satisfaction of preferences as its normative criterion. 8

9. But the findings of behavioural economics cast doubt on whether coherent preferences really exist. In many cases, individuals’ economic behaviour reveals incoherentpreferences; the incoherencies (‘anomalies’) are systematic and can be explained psychologically. A few examples: -- preferences between two options depend on which is perceived as the status quo (the ‘endowment effect’, ‘loss aversion’); -- preferences revealed in choices are not the same as preferences revealed in valuations of the same objects (‘preference reversal’); -- preference between A and B varies according to whether C is in the opportunity set (‘decoy effect’: if C is clearly inferior to B, but not to A, adding C to the set makes B more attractive). If preferences are incoherent, how can preference-satisfaction be used as a normative standard? 9

10. In behavioural economics, a consensus seems to be developing around a particular response to this problem: libertarian paternalism/ asymmetric paternalism/ soft paternalism/ behavioural welfare economics. This has become influential both within academia and outside: -- Thaler and Sunstein’s popular book Nudge; -- Thaler recently visited 10 Downing Street to advise the ‘behavioural insight team’ or ‘Nudge unit’ on how to apply his approach to public policy. This approach is often presented as a challenge to the idea of the invisible hand. I’ve responded to this challenge in a series of theoretical and philosophical papers.* This lecture summarises the arguments I have been developing. * Including: American Economic Review 2004; Social Choice and Welfare 2007; Constitutional Political Economy 2008; Economics and Philosophy 2008 (with Bruni); Economics and Philosophy 2010. 10

11. In part, my argument will be a critique of behavioural welfare economics. Not of the specific policy proposals advanced by behavioural welfare economists, which are often quite sensible (e.g. regulations on displays of tariffs to facilitate price comparisons), but of the theoretical approach that they are using. This is fair: behavioural welfare economics is presented as a whole new way of thinking about normative economics (‘the real Third Way’ – Thaler and Sunstein). But my argument will also be a critique of the way that the invisible hand idea has been understood by neoclassical economics. 11

12. Neoclassical economists have represented Smith’s insight in theoretical models in which economic agents are rational and in which the satisfaction of rational preferences is the standard by which institutions are evaluated. In these models: markets are efficient in satisfying preferences. The findings of behavioural economics do challenge this understanding of the invisible hand idea. My response is to develop a different understanding of what markets do for us, which retains the insights of the liberal tradition of Smith, but is compatible with behavioural findings. 12

13. What is behavioural welfare economics? Two (remarkably similar) manifestos appeared in 2003: Cass Sunstein and Richard Thaler. Libertarian paternalism is not an oxymoron. University of Chicago Law Review, 70 (2003): 1159-1202. [The academic paper that was expanded and popularised as Nudge.] Colin Camerer, Samuel Issacharoff, George Loewenstein, Ted O’Donaghue and Matthew Rabin (2003). Regulation for conservatives: behavioral economics and the case for ‘asymmetric paternalism’. University of Pennsylvania Law Review 151 (2003): 1211-1254. Each paper has a legal scholar as a co-author. Otherwise, a roll-call of the great and the good of American behavioural economics. Titles (‘libertarian paternalism’, ‘regulation for conservatives’) signal that the authors will propose interventions in the economy that have traditionally been opposed by pro-market thinkers – but the authors’ arguments will be immune to their opponents’ usual criticisms. 13

14. These papers implicitly criticise traditional welfare economics, but do not explain how, if their authors’ proposals are accepted, welfare economics should be reconstructed. Sunstein and Thaler’s most concrete advice: public decisions should be based on ‘a form of cost-benefit analysis’ whose goal is ‘to measure the full ramifications of any design choice’. (No discussion of how to measure costs and benefits when individuals don’t have coherent preferences.) Similarly unspecific suggestions about cost-benefit analysis by Camerer et al. More concrete proposals for reconstructing welfare economics are now being made. For example: Douglas Bernheim and Antonio Rangel. Beyond revealed preference: choice-theoretic foundations for behavioral welfare economics. Quarterly Journal of Economics 124 (2009): 51–104. Esssentially: Bernheim and Rangel take the approach advocated in the 2003 manifestos and try to adapt theoretical welfare economics to fit it. 14

15. In this lecture, I’ll focus on the principles of behavioural welfare economics, as advocated by Sunstein and Thaler. Richard Thaler Cass Sunstein And I’ll focus on one of Sunstein and Thaler’s central claims (in opposition to traditional welfare economics): The findings of behavioural economics force us to recognise that paternalism is ‘inevitable’; the idea that there are ‘viable alternatives to paternalism’ is a ‘misconception’; the anti-paternalist position is ‘incoherent’, a ‘nonstarter’. 15

16. Why (according to Sunstein and Thaler) is paternalism inevitable? Traditionally, economics has assumed that individuals have coherent preferences which are prior to the decision situations in which they are revealed. If that assumption were true, it would make sense to ask whether those preferences should be respected. The anti-paternalist would say ‘Yes’, the paternalist would say ‘Perhaps not’. But in fact, individuals often form their preferences only when confronting specific decision problems. Those preferences are sensitive to apparently arbitrary details of framing (e.g. endowment effect, preference reversal, decoy effect…). So, the anti-paternalist’s principle (respect preferences) can’t be applied: the objection to paternalism fails. That in itself doesn’t make paternalism inevitable, only unobjectionable. But … 16

17. Sunstein and Thaler conceive of themselves as advising a ‘planner’ (later: ‘choice architect’) who is responsible for designing the presentation of options to individuals. If individuals’ preferences are sensitive to framing, the planner’s choice of frame can affect the preferences that individuals reveal; there is no way of simply standing back and respecting preferences. So the planner cannot avoid a decision about the direction in which to steer the individual, and the only reasonable criterion for making this decision is the planner’s judgement about the individual’s best interests. This is the sense in which there are no viable alternatives to paternalism. But if the planner’s only intervention is to set the framing, individuals remain free to ignore that framing. Thus, this form of paternalism can still be called ‘libertarian’. 17

18. Sunstein and Thaler’s favourite example of libertarian paternalism: the cafeteria. Consider the cafeteria ‘at some organisation’ … (Let’s say: the cafeteria at the University of East Anglia...) 18

19. Customers proceed along a line, choosing food items from a display, until they reach the checkout. The cafeteria director notices that given items are more likely to be chosen if they are placed earlier in the line. On the basis of current medical knowledge, she judges that most customers would be better off if they ate fewer sweet desserts and more fruit. Which should she display first, the fruits or the desserts? 19

20. Sunstein and Thaler draw up a shortlist of four rules the director might follow in deciding how to display food items. Two really are non-starters: ‘choose at random’ and ‘make the customers as obese as possible’. This leaves two plausible contenders: 20

21. ‘She could give customers what she thinks they would choose on their own’ [notice ‘give’ …]; or (2) ‘She could make choices that she thinks would make the customers best off, all things considered’. An anti-paternalist would favour (1), but this rule is meaningful only if ‘what the customer would choose’ can be defined independently of the director’s choice. But it can’t: ‘consumers … lack well-formed preferences, in the sense of preferences that are firmly held and preexist the director’s own choices about how to order the relevant items. If the arrangement of the alternatives has a significant effect on the selections the customers make, then their true ‘preferences’ do not formally exist.’ So the cafeteria director has to use (2). 21

22. And in the UEA cafeteria ... 22

23. Another view ... 23

24. The shortlist of rules for the director didn’t include ‘Choose the display that maximises profit’. The (later) Nudge version of the story (now set in a school) does, but: ‘[This rule] has some appeal, especially if Carolyn [the director] thinks that the best cafeteria is the one that makes the most money. But should Carolyn really try to maximise profits if the result is to make children less healthy, especially since she works for the school district?’ The reference to children is a diversionary tactic(S&T are proposing paternalism for adults). The thought seems to be that a cafeteria manager should be concerned with the welfare of her customers, and not just ‘making money ’. If coherent preferences existed, they might be treated as indicators of customers’ welfare (and so making money would produce welfare) – but they don’t exist. Implication: if individuals’ preferences are incoherent, the usual argument for the market (i.e. that it satisfies preferences) is invalidated; then, paternalism is the only defensible response. 24

25. Are Sunstein and Thaler being too neoclassical? S&T instruct the planner (or cafeteria director) to nudge individuals towards the choices that are in their best interests. But how is ‘best interest’ judged? S&T spend much more time discussing how people can be nudged than on how the planner decides in which direction to nudge them. But their official position is to use an informed desire or true preference criterion. Individuals are treated as not acting in their own best interests if their decisions are ones ‘they would change if they had complete information, unlimited cognitive abilities, and no lack of willpower’. Implication: a person’s best interests correspond with the preferences he would reveal if he had complete information, unlimited cognitive abilities, and no lack of willpower. Notice the implicit assumption that true preferences exist, and are coherent. What justifies this true preferences assumption? 25

26. Sunstein and Thaler are effectively assuming that, inside every ‘behavioural’ human being, there is a neoclassical rational agent. The rational agent’s optimal choices are frustrated by imperfections that are ‘external’ to it,(imperfect information, imperfect cognition, imperfect self-control). This idea doesn’t fit well with the methodology of behavioural economics – the concept of true preferences seems to have come from a priori rational choice theory, not empirical psychology. Information, cognition and willpower are all inert without desires to act on. Superhuman agents who had perfect information, perfect cognitive powers and perfect willpower would still have to deal with their actual desires, which are matters of psychology, not rationality. ‘Anomalies’ in human decision-making (i.e. deviations from rational-choice theory) may reflect the structure of desires (e.g. loss aversion), not ‘error’. So perhaps S&T are being too neoclassical. (I think my approach is more behavioural as well as more liberal!) 26

27. Behavioural welfare economics: the fundamental logic Think about the structure of Sunstein and Thaler’s argument: 1. Welfare economics is addressed to a planner, who decides what individuals should be given (not to citizens who decide whether they want to have a planner, or to choose for themselves how to spend their own money). 2. The planner seeks to maximise the welfare of each individual (other things equal). There is a presumption that preference is an indicator of welfare. So, if the individual has coherent preferences, the planner gives him what he prefers. 3. The market may be a convenient mechanism for doing this (the invisible hand argument); but the justification of the market is that it gives each of us what the ideal planner would give us. 4. If individuals’ choices are influenced by ‘arbitrary’ factors, the data provided by revealed preferences (and on which the market operates) are corrupted. So the invisible hand argument for the market fails. 27

28. Two concerns about this form of argument 1. Mismatch between the liberal tradition to which Adam Smith belongs and the idea of defending the market by taking the viewpoint of a planner, for whom individuals’ choices are just a source of data. 2. If the argument in support of the market really applies only when individuals have consistent preferences, its power is very limited. We all know that our preferences are affected by ‘arbitrary’ factors (e.g. tendency to favour status quo, sensitivity to the way goods are displayed, influence of other people ...). ‘Given’ preferences is a modelling assumption, not a fact about the world. These concerns are not specific to behavioural welfare economics – they apply to neoclassical welfare economics too. 28

29. An alternative approach Behavioural and neoclassical welfare economics interpret the invisible hand argument as claiming that markets are effective in satisfying given preferences. (First we specify preferences, then we ask whether the market satisfies them.) I propose that we reformulate the invisible hand argument as claiming that markets allow individuals to satisfy their preferences, whatever those preferences turn out to be. (We evaluate the market from the perspective of individuals who do not yet know what their preferences will be.) Preference inconsistencies disable the first approach, but not the second. 29

30. Reconstructing the first fundamental theorem of welfare economics This theorem is generally seen as the core neoclassical statement of the invisible hand argument. Roughly, it says that competitive markets are efficient in satisfying preferences. I’ll show how the theorem can be reconstructed so that it doesn’t refer to given preferences. (Just the first step in a bigger project ...) First, I’ll state the theorem more precisely, as applied to a very simple exchange economy. 30

31. In this economy, there are many individuals. There are many goods, all of which are private. There is a fixed stock of each good, so the only economic problem is to divide these stocks between individuals. Any division of goods between individuals is an allocation. We start with an initial allocation (individuals’ endowments). Individuals are then able to exchange goods by mutual consent. Competitive equilibrium is a list of prices, one for each good, such that all markets clear (i.e. for each good, total amount offered for sale = total amount demanded). Trade at these prices brings about a new allocation. It’s assumed that each individual has a ‘given’ preference ranking over all bundles of goods, and acts on this. An allocation is Pareto-optimal if no feasible reallocation of goods between individuals would make some individual better off and no one worse off (in terms of their preferences). The theorem tells us: every competitive equilibrium is Pareto-optimal.

32. A sketch of a proof of the first fundamental theorem Deliberately, the proof is not quite standard. It proves as much as possible using only the most minimal assumptions about preferences, and introduces rationality assumptions at the very end. This allows us to identify desirable properties of the market that don’t depend on rationality assumptions. Preliminary. Competitive equilibrium can be defined without using the concept of preference (or ‘utility’). Conventionally, ‘demand’ and ‘supply’ (and hence market-clearing) are defined in terms of utility-maximising choices. But all we need to assume is that individuals make decisions about how much to buy and sell at the prices that are on offer. These decisions need not reveal consistent preferences (e.g. desired holdings of goods may depend on endowments, and/or on ‘arbitrary’ framing features). All I assume about preferences is that one good (‘money’) is always desired. 32

33. A possible doubt: Competitive equilibrium is defined as a list of market-clearing prices. In neoclassical welfare economics, this is treated as an idealised representation of the outcome of real markets. For this idea to be plausible, do we need to assume that individuals have consistent preferences? No. It’s sufficient that trades are mediated by profit-seeking professional traders (who are ‘rational’ in their professional activities). No one needs to have consistent preferences over bundles of goods. [I show this in a paper in American Economic Review 2004.] 33

34. Step 1 of proof: In competitive equilibrium, all opportunities for voluntary transactions have been made available to individuals (severally). Let Z be the initial allocation. Let X be the allocation reached in a competitive equilibrium, by trades from Z made at the price list P. What would it mean to say that some opportunity for voluntary transaction had not been made available? Suppose that were so. Then there would be: (a) a feasible allocation Y (not the same as X), reachable from X by some composite transaction; and (b) no party to that composite transaction (i.e. no individual whose bundle in Y is not the same as his bundle in X) has been offered his part of the transaction and has rejected it. But in fact, for any Y satisfying (a): at least one party to that transaction was offered his part of it through the market, and chose not to take it. 34

35. How do we know this? X (the outcome of the market) and Y (the outcome of the composite transaction) contain exactly the same goods. (In this economy, the only possible transactions are exchanges.) So: value of Y at market prices = value of X at market prices. For each party to the transaction we can ask whether his Y-bundle is worth more or less (at market prices) than his X-bundle. Clearly, it can’t be the case that every party ‘gains value’ in the transaction. So there must be at least one individual i, who is a party to the transaction, and whose Y-bundle is worth no more than his X-bundle. But i had the opportunity to buy his Y-bundle (or one unambiguously better) at the market prices, and chose not to do so. Which proves: In competitive equilibrium, all opportunities for voluntary transactions have been made available to individuals. 35

36. Step 2 of proof:If each individual acts in accordance with a stable preference ordering, then competitive equilibrium is Pareto-optimal. For simplicity, I assume that preferences are strictly convex (i.e. there is a uniquely optimal choice from every budget constraint) – this isn’t essential. From Step 1, we know that if X is the outcome of the market, then for every other feasible allocation Y, there is at least one individual i who chose not to take his Y-bundle in exchange for his X-bundle. So, i prefers his X-bundle. So, every feasible reallocation of X makes at least one individual worse off. QED. 36

37. The significance of this proof: Behavioural welfare economists claim that the invisible hand argument is undermined if individuals lack coherent preferences. But coherent preferences are needed only for Step 2. Step 2 converts ‘In competitive equilibrium, all opportunities for voluntary transactions are made available’ into ‘Competitive equilibrium is Pareto-optimal’. This step switches from individuals’ perspectives to the planner’s perspective. The planner is trying to maximise each individual’s welfare; she treats ‘given’ preferences as indicators of welfare; so she needs to show that opportunities for voluntary transactions translate into the satisfaction of given preferences. But: For each of us as individuals, assessing what the market does for us, isn’t ‘All opportunities for voluntary transactions are made available’ sufficient? Do we need the planner’s viewpoint? 37

38. How the market gives us what we want My representation of the invisible hand: The market gives each of us what we want and are willing to pay for, when we want it and are willing to pay for it. 38

39. The market gives each of us what we want and are willing to pay for, when we want it and are willing to pay for it. ‘Willing to pay’ = willing to give up what would induce others to take part in the transaction. ‘When we want’: the market responds to our preferences, whatever they may be, at the moment at which we transact (and so, whatever framing is in place at that moment). It takes no notice of whether our preferences are ‘consistent’ or not. If trading takes place over time, the market responds to our preferences at all trading moments. If I change my mind from one moment to another (e.g. today I want to sell my Nissan and buy a VW, next week I want to sell the VW and buy the Nissan back), the market gives me what I want and am willing to pay for at both moments (in effect, facilitating a trade between ‘me now’ and ‘me next week’). 39

40. Is this property of markets good for each of us (from our own viewpoints)? Let me try to persuade you that, all things considered, this is good for us, even if our preferences don’t meet the standards of neoclassical economics. 40

41. An analogy: Suppose you need to go shopping to buy food for your next meal. You haven’t decided what you want to eat. You expect that you will decide only when you are in the shop, seeing what is on offer (and perhaps being influenced by the displays). At the moment, all you have to decide is which shop to go to. There are two grocery stores, roughly equally distant... 41

42. A small shop, with a limited range of products... 42

43. and a large supermarket, with a much wider range... Which shop would you go to? 43

44. I would go to the big supermarket. (From trends in the grocery market, I infer that many people would make the same choice.) Why? Not because it is more effective in satisfying my existing preferences for meals (these preferences are not yet defined) ... ... but because it will give me more opportunity to buy what I want, when the time comes to choose. Whatever my preferences turn out to be, I will be better able to satisfy them at the larger store. This is true, however different my preferences then are from my preferences now. To see this as ‘good for me’, I don’t need to ask what future choices would be best for my welfare. I just have to be willing to delegate future decisions to my future self. 44

45. The point of this analogy: opportunity can be valued by someone who can’t predict how he will use it, and who recognises that his preferences may be subject to ‘arbitrary’ variation. To recognise this value, you have to take a particular attitude to your future ‘selves’: responsibility. You (i.e. you-now, reflecting about your continuing interests) have to identifywith your future selves. You have to see ‘their’ actions as yours, whether or not these are the actions that you-now would choose. Taking this attitude, you-now want it to be the case that you-then are able to get what you-then want. So, you see all opportunities, present or future, as good for you.

46. Economists find this way of thinking about future selves surprisingly difficult to grasp. Because economists like using rational-choice models, their inclination is to model the relationship between selves as a game between agents with conflicting interests. In these models, the present self thinks of the future self as if it were a different person, liable to frustrate the present self’s intentions. So, in cases like the supermarkets, they immediately think about self-control problems... What if I-now am worried that the supermarket displays will tempt me-then to buy something that I-now think would not be good for me-then? Can I-now use the choice of the smaller supermarket as a way of constraining me-then? And so on... 46

47. Of course, genuine self-control problems (i.e. cases where people want to impose constraints on themselves) do sometimes occur. But I suggest that these problems are far, far less common than cases in which people can’t fully predict their future preferences, have no expectation that their preferences will be consistent, but have no desire to impose their present preferences on their future selves. For most of us, most of the time, it is entirely sensible to delegate future choices to future selves. So, if markets tend to give us what we want, when we want it, that’s not such a bad deal. 47

48. Back to Sunstein and Thaler’s cafeteria... In a competitive market, what displays will cafeteria managers choose? Obviously: the displays that maximise profit. So, the more costly forms of display will be used for the products for which display has the largest impact on customers’ willingness to pay. I conjecture: chocolate- and cream-rich desserts offer more scope for this form of added value than apples and bananas. 48

49. Compare a supermarket-style display of cakes ... 49

50. ... with a coffee-shop display. The coffee-shop display is more costly, but also more tempting. 50