While a part of public policies deals with market and government failures which are highlighted by welfare economics and public choice economics respectively, recently surged trend is the impact of ‘individual failure’ on the public economics.
Suppositions about psychology/behavior are a crucial part of the policymaking. An analyst may customize the problems defined, set individual objectives and recommend policy ex post based on the findings.
Both traditional public finance and public choice schools have focused on the ‘representative’ individual. In Neoclassical Welfare economics, this individual is homo oeconomicus (Econ). By this assumption, people behave by making fully rational decisions by acquiring complete information and by acting in self-interest. Econ’s preferences are assumed to be exogenous and constant, then the predictions may be premised on the response Econs make to changes in constraints (i.e., tax, subsidy or regulation altering the budget constraint).
However, the Homo-Realitus (Human) differs systematically from the behavior that economists describe as ‘rational’. Humans are reliant on bounded rationality, which is the main factor for ‘individual failure’, they are concerned with more than just self-interest and they internalize the preferences, namely they are more responsive to signals that influence preferences.
Traditional economics has focused mainly on the ‘rational’ actors’ rational behavior. However, as already has been proven, the departures from the rationality, called anomalies, are very ubiquitous and persistent. So, as this departure from ‘rational’ behavior of Econs is systematic, implications on public finance and public choice may be and should be analyzed from the Humans’ perspective, not the Econs’.
Most decisions in the world are made under uncertainty (including the policies). A person could never gather all the relevant pieces information, work how to fit together and ensure the exact impacts. So, the factors irrelevant to traditional economics (such as beliefs, culture, peers, learning, etc.) becomes crucial in behavioral economics and related fields.
So, if people do not possess a complete and perfect information, how do they make decisions for a course of action? According to the behavioral economics, they gather facts and beliefs about their world as they experience it and by seeing how other people experience it. Besides acquiring as much information as possible, it might be necessary to use a rule of thumb to make decisions, and these rule of thumbs are called heuristics. There are many findings for heuristics and biases by Kahneman and Tversky. The two main heuristics that matters the most to policy analysis is the Endowment effects and Loss Aversion.
When individuals act irrationally, there are implications in terms of the way that governments should value ‘costs’ and ‘benefits’ to maximize welfare, the way they should intervene to protect citizens and the way they should design policy to win compliance.
Sources: Kahneman & Tversky (1974); Ministry of Economic Development New Zealand (2006), Cullis & Jones (2009)