Linking welfare economics with behavioral economics…impossible?

A superb post from . What a blog Worthwhile Canadian Initiative is..

We keep mentioning about the interesting findings and applications of behavioral economics. However, how does one really fit the findings in other economic streams? If one brings the irrationality assumption in say Price theory, how will graphs etc change.  You get  some idea here as Prof Woolley links to welfare economics.

The case here is banning large sodas. Typically welfare economics assumes rational behavior. So banning large sodas leads to demand being higher than supply, leading to deadweight loss:


Analysis of deadweight loss is a very simple type of “welfare economics” – the study of how projects and policies affect people’s well-being, or welfare. Implicit in standard welfare economics is the assumption that people know what is in their own self-interest, and act upon it. If people drink extra-large sodas, it must be because the enjoyment they get from drinking sodas outweighs the costs, for example, weight gain and increased risk of diabetes. Unless soda drinking harms other people, any analysis that begins with the premise that people’s actions are based on rational self-interest must inevitably reach the conclusion that soda bans reduce welfare.

Bring in behavioral economics. It says people are irrational and don’t make choices thinking much. So unlike rational school which thinks more is better, here people are not sure. So we have a graph where demand curve is really thick and we could have multiple chopices:

People are not totally devoid of sense; they cannot be persuaded to buy just anything. But, at any given price, a consumer might be persuaded by buy any quantity between Q1 and Q2, depending upon how the consumption choice is framed, or marketed. Any quantity within this range could be the observed outcome of a “rational choice” at the price shown. In this world, a soda ban simply nudges the consumer from point Q2 – grabbing an extra-large soda – to Q1 – grabbing a large soda. 

This leads to a q. How does beh eco guy knows whether someone likes Q1 or Q2?

Yet this begs the question: how does the behavioural economist know which is better, Q1 or Q2? Sometimes, as in the case of sodas, the behavioural economist urges consumers to consume less. But when it comes to, say, savings, behavioural economists work in the other direction, creating nudges that get people to save more. But how does a behavioural economist know which direction the consumer should be nudged in?

One possibility is to replace the old tools of welfare economics – consumer and producer surplus – with health and happiness. Does drinking less soda increase health? Are people who drink smaller sodas happier, all else being equal, than people who drink extra-large ones? If so, then the ban may be good policy.

Health and happiness are not the only metrics by which behaviouralists judge choices. Thaler and Sunstein, for example, argue that each of us has an internal planner, a sensible person who would like to make rational choices, but who is defeated by our internal Homer Simpson. In this view, the behaviouralist is just helping us do what our inner planner would like. Yet how do we know what people’s inner planners really want?

Big challenges to link welfare with beh eco:

While I am sympathetic to behavioural economics, I worry about the consequences of viewing all policies through the lens of health. Some of the best things in life are also somewhat dangerous – like swimming across a lake with only the moon and stars for company. At the same time, I want to live in a world where I’m nudged towards healthy choices – where it’s easy to get around by bicycle, for example, and the university cafeteria serves reasonably nutritious meals.

Welfare economics teaches us to respect people’s choices. Behavioural economics urges us to protect people from making dumb choices that they’ll regret later. I don’t know of any way of resolving these two views.

Hmmm.. Really well put like several previous posts..The comments are really interesting as well.

Well, the rational school has conveniently assumed and summarised the choices and trade-offs people make in highly simplistic manner. Reality is far more complex..

But an amazing explanation from Prof Woolley…


One Response to “Linking welfare economics with behavioral economics…impossible?”

  1. Vikram Says:

    Succinct characterization of Behavioural and Welfare Economics.

    With the Soda Ban one of the justifications that is claimed is that it will reduce healthcare costs due to reduced incidence of Diabetes and Obesity. Now this means there’s an externality right now. The ban on large sodas then is an attempt to reduce this damage by means of regulation rather than a Pigouvian tax (Which Bloomberg tried to bring about some time ago). Either way, there is also a welfare basis to the rule rather than only behavioral.

    Maybe not so much in this example, but sometimes the behavioral aspect is hard to distinguish from the welfare. Attempt to Suicide, for example, is recognized as a crime for which the person is prosecuted by the state. Thereby implying that the suicide attempter’s happiness is part of society’s happiness. (I’m assuming suicide is never a rational choice nor will it make the person happier)

    Where this implication cannot be drawn, is where we’ll have a conflict between behavioral and welfare economics.

    There is one small issue with behavioural economics as a rationale for policy. Should the state put each person in a position to make that rational choice or should it hoodwink him into it? For example statutory warning on cigarette packets is supposed to help the person make a rational choice by reminding him of the information which is relevant to him making a rational choice. With the soda ban, it’s basically using the default bias in people rather than letting them choose each time. Which makes me wonder, if it would be better to have a statutory warning on Extra large soda saying “Soda makes you fat and diabetic” or something of the sort.

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