Thursday, June 7, 2012

Nudge by Richard H. Thaler and Cass R. Sunstein

Source of book: Borrowed from the library

First of all, I must state that my wife is a hypocrite. It’s true. But first, let me explain what this fascinating book is about. 

Thaler is an economist, while Sunstein is a lawyer, but was appointed to serve in the Obama administration. Their book, published before the election, addresses the question of default settings in public policy, and the use of what they call “nudges” to assist people in making good decisions. 

Thaler and Sunstein advocate a position they call “libertarian paternalism.” At the heart of this concept is the idea of a default setting - that is, what happens when people do not take action. A great example of this is the 401(k) retirement account. In order to start contributing to such an account, one must take action by signing up. In addition, one must choose which investments are used. The default setting at this time is “no contributions,” which is surely a poor default. This is doubly (or more) so, in cases where an employer matches contributions. The default is to lose free money!

There are other possible defaults here, including a default that 401(k) contributions are set at the maximum, or that they are set at the level of the maximum employer match. Another possibility is that the employee be forced to explicitly choose before he or she receives the first paycheck. The result of the current default is that nearly everyone says they want to contribute more, but far too many never overcome the inertia and sign up. 

A related problem is that of choosing investments. Most plans have numerous funds as options, and most investors are fairly unsophisticated when it comes to choosing them. Most of us would prefer some guidance to appropriate investments. (I am an exception here: I love doing the research, and educated myself before opening my own SEP IRA accounts.) The point here is that it suddenly becomes extremely important to set appropriate defaults. As the authors point out, something will be the default: it is impossible to avoid it. Space prevents the discussion of the Swedish social security system. (Yes, it’s true. The socialist Swedes have partially privatized their social security system.) The authors’ look at the results of various defaults tried by the Swedish government over the last decade is illustrative of the power of the default setting.

Now this is where my wife is a hypocrite. She has generally been purely libertarian in her philosophy toward retirement contributions - far more libertarian than me. Although she does contribute to her retirement at the matching rate, she set her accounts essentially at the default, and cannot really explain what she has invested in and why. She has accepted the defaults, and many others are like her. (I mean nothing negative here - it's just human nature - but many libertarians seem intent on denying or ignoring this fact.)

Here is where Thaler and Sunstein believe in the use of “nudges.” These are essentially the use of defaults and reminders in ways that do not abridge the freedom of choice, but assist those who tend to settle for defaults in making better decisions. In order to qualify as a nudge, the authors believe that the cost of overriding the nudge should be as low as possible - preferably zero. In the above example, if the default for retirement contributions was, say, five percent of income, it would qualify as a nudge as long as the employee could easily opt out. (The change would be from “opt-in” to “opt-out.”) 

Central to the idea of the “nudge” is that people are “humans” rather than “econs.” The typical libertarian economist believes that people always educate themselves, consider the options, and pick what they want. In other words, they make decisions that are in their best interest. People like this exist, and the authors call them “econs.” Most of us, however, are “humans” in how we behave. We fail to act logically in all situations. We procrastinate, and react rather than think - at least in some cases. We are particularly prone to get into trouble on serious issues wherein the cost is incurred immediately, but the reward is in the future. We struggle to get complex issues correct, which is a particular problem in cases where we do not get the opportunity to practice, such as in saving for retirement. These are the precise scenarios where the authors think that nudges can be helpful. 

A great example of the “human” tendency can be seen in an experiment involving intentionally stale popcorn, which was served in different sized containers. It was rather universally agreed among the participants that the popcorn was gross, and yet those with larger containers ate more. By a lot. Even though they hated the popcorn. 

Another interesting “human” tendency was to have difficulty assessing risk. For example, most people will estimate the likelihood of divorce to be fifty percent - at least for other people. For themselves, they consistently estimate a zero chance. Obviously, this cannot be right, but the human tendency is to disregard certain risks and overestimate others. (This could be an entire book by itself.) 

Another reason the authors think nudges are important is that humans tend to follow the herd. We naturally want to do what we believe other people are doing. By shifting the default, the herd mentality can be used to produce better results. The authors cite the Jamestown Massacre as a negative example, but also note that the herd mentality has also been used to reduce littering. This part of the discussion was seriously unsettling, particularly the experiments that have been done involving peer pressure. People are amazingly unwilling to stand for their own opinions if they have to do so against a crowd. On the positive side, it was shown that consistent and unwavering people can have immense influence for good, as well as evil. 

Libertarians, of course, tend to oppose nudges, for a number of reasons, some better than others. The authors are proposing what they believe is a third way, between the “command and control” paradigm of modern, post Franklin Roosevelt liberalism; and the laissez faire approach of libertarian conservatism. The authors correctly note that many companies and individuals have a strong financial incentive to cater to people’s ignorance and frailties and exploit them. A good example cited here is the mortgage business, where fine print and complexity are routinely used to hide the true cost from consumers. 

The goal that the authors set is to determine how to use nudges, rather than command and control schemes to protect the less sophisticated and the vulnerable. The intention is to benefit the “humans”, with a minimal cost to the “econs.” In the context of retirement, there should be a miniscule cost - if any - to a default that leads to a greater investment in retirement by those who fail, for whatever reason, to go beyond the default. It should not bother those of us who actively manage our retirement accounts if someone else also does well. If it does, perhaps we should be evaluating why we wish to see others hurt. Do we just want to look down on others we deem less intelligent than ourselves? Something to ponder. 

I felt that the authors made their point well, and present a powerful argument in favor of libertarian paternalism. It is with regret that I note that, despite Sunstein’s presence, the Obama administration has chosen in most cases to go with a command and control approach, rather than a “freedom and nudge” approach as that advocated by the authors. I think that the “third way” proposal would be attractive to both sides of the aisle: more protection against our frailties (and from exploitation), combined with greater freedom of choice - and from onerous regulatory compliance. 

Note on some specific proposals: The authors address a few ideas, such as the use of a carbon tax or a cap and trade scheme to reduce pollution. They contrast it, however, with a command and control scheme, in which byzantine or draconian regulations cause costs to both those who pollute and those who comply. They also come down in favor of school vouchers, as increasing freedom, while setting defaults so that it is harder for the more sophisticated to game the system. They also advocate for privatizing marriage. All of these proposals are worth considering, whether you agree with them or not. I thought they were food for thought, and should be considered in contrast to the current state of affairs, not just in the abstract.

Note on peer pressure: A quote from this section made me smile, although it is not directly on point:


Conventional wisdom has it that if two people live together for a long time, they start to look like each other. This bit of folk wisdom turns out to be true. (For the curious: they grow to look alike partly because of nutrition - shared diets and eating habits - but much of the effect is simple imitation of facial expressions.) In fact couples who end up looking alike also tend to be happier!

Note on notes: The authors use their own version of a nudge in how they format the notes, which they explain at the outset. Most citations and other notations are presented as endnotes at the back of the book. These are interesting to people like me, who occasionally wish to check a citation source. However, certain other notes, which the authors assume the average reader would like to see immediately, without flipping to the back, are placed as footnotes. I wish more authors did things this way. I hate having to go all the way to the end for a note that can be a useful explanation of the text, but would hate to have all the citations right there and in the way. Brilliantly done!

Note on Shel Silverstein: The authors wished to use Silverstein’s poem “Smart” as an illustration. It was perfectly on point, and charming. Here is how the authors describe what happened: 


To analyze the question, let’s start with a simple example inspired by a wonderful poem by Shel Silverstein (1974) entitled “Smart.” The poem is fun as well as brilliant, so if you have a computer nearby, we suggest you type “Smart” and “Shel Silverstein” into Google and read the poem now.* We will wait for you to get back before continuing.

*Silverstein had personally given Thaler permission to use the poem in an academic paper published in 1985 - he said he was tickled to see his work appear in the American Economic Review - but the poem is now controlled by his estate, which after several nudges (otherwise known as desperate pleas), has denied us permission to reprint the poem here. Since we would have been happy to pay royalties, unlike the Web sites you will find via Google, we can only guess that the managers of the estate (to paraphrase the poem) don’t know that some is more than none. 

Since I think I can get away with quoting a single poem under the fair use doctrine, I will reproduce it here.

My dad gave me one dollar bill
'Cause I'm his smartest son,
And I swapped it for two shiny quarters
'Cause two is more than one!

And then I took the quarters
And traded them to Lou
For three times -- I guess he don't know
That three is more than two!

Just then, along came old blind Bates
And just 'cause he can't see
He gave me four nickels for my three dimes,
And four is more than three!

And I took the nickels to Hiram Coombs
Down at the seed-feed store,
And the fool gave me five pennies for them,
And five is more than four!

And then I went and showed my dad,
And he got red in the cheeks
And closed his eyes and shook his head--
Too proud of me to speak!

1 comment:

  1. Great. Yet another book you reviewed that I need to add to my (rapidly-growing) to-read pile.

    Enough already with the great book reviews! :)