Usually, voluntary exchange without any external intervention leads to an efficient allocation of goods and services under the ideal market conditions. This is justified by the fact that prices coordinate the activities of buyers and sellers and transmits necessary information about the strength of demand and supply.
Nonetheless, this type of efficiency is not an ideal one, because there are instances in which market fails to lead to an efficient end. It is argued that there are two possible reasons: 1) Market Power- where the producers are price makers who decides on the production of a less thane efficient quantity of goods; 2) Non-existence of markets- occurs for reasons such as asymmetric information, public goods and externalities.
For a long time, economists have proposed the policymakers to rely on market-based principles in designing policies to address such market failures. However in recent years, economics shifted from orthodox approach to a new perspective of evaluating the market failures and justifying the intervention in the economy. Instead of market principles, the research has focused on identifying the behavioral failures (or biases) that make choices that cause self-harm or, at least, no improvement.
Condone, Mullainathan, and Kling allocates these deviations of standard economic assumptions into three categories: Imperfect optimization, bounded self-control, and non-standard preferences. Imperfect optimization refers to an argument that people are not good at making decisions concerning their own well-being. Bounded self-control argues that even when people know what they want, they are still not able to act on these interests (i.e. procrastination, succumbing to immediate temptation). The non-standard preferences challenges the orthodox assumptions about choice, such a as that people decide based on the value they put at the end state rather than at the means to that end.
Even though the Behavioral Economics has been in existence for a long time, the application of the field into Public Choice is very new. Soft Paternalism and nudging are being born from this application. These policies seek to change the architecture of the choices to individuals in order to encourage a more relevant and pareto-improvement outcome. However, the policymakers, politicians and regulators, as the behavioral agent-individuals themselves, are very prone to the same behavioral limitations and biases. Behavioral economics leads to a paradox in requiring more of policymakers- such as new judgments about identification and modification of behavioral deviations, and at the same time suggesting that those policymakers’ that find these tendencies also tend to show the similar limitations in their (ir)-rational behavior. As Cass Sunstein states, ‘for every bias identified for individuals, there is an accompanying bias in the public sphere.”
There are two specific reasoning for suboptimal decisions of regulatory responses. Firstly, as behavioral agent-individual themselves, regulator and policymakers are not defended from the behavioral biases that affect the citizen-individuals. The second reason is that the regulator are subject to public choice incentives that could result in more reduction of welfare, and indeed take a path tot he misuse of behavioral findings by the policymakers to extend the power or to favor the special interests of minority parties over the public welfare.
Instead of just observing the actions of regulators, let’s first go back one step to see how these welfare maximizing policies are being chosen. Researchers mainly argue that private decision-making might be less prone to mistakes than public decision making. One of the important arguments is that behavioral limits in citizens suggest bad decision making in their voting activities as often as in their market activities. Since the median voter determines the policy response, having a behavioral biases it may just choose a suboptimal policy. Namely, in a democratic system, theory and evidence suggest that government policies reflect the irrationalities of ordinary people. Another reason is that the private decision-makers have stronger incentives to find and apply information- considering the opportunity cost- to overcome psychological limitations, since the individual costs to a citizen making a suboptimal decision are higher than the individual costs to the policymaker whose decision brings suboptimal outcome. The power also has an impact on the decision making, so a small powerful group’s influence might lead to an inefficient policy if it is greater than the preferences of majority.
All these factors support the argument that the regulators and policymakers, as behavioral agents themselves, are vulnerable to make suboptimal decisions by the influence of manipulation and behavioral anomalies.
Sources: Viscusi & Gayer (2015), Sunstein (2012), Mullainathan et al (2011)