New Economist

Nudging behaviour: When incentives do (and don't) work

Behavioural economics has blossomed in recent years, to the point that the Fall 2011 edition of the Journal of Economic Perspectives can, along with articles on neuronomics, genetics and retirement, include a fascinating 20 page review paper on incentives. That's not surprising; a lot of people have taken an interest in them lately, including President Obama and Britain's prime minister.

When and Why Incentives (Don’t) Work to Modify Behavior was written by Uri Gneezy from the University of California–San Diego, Stephan Meier from Columbia Business School, and Pedro Rey-Biel at the Universitat Autònoma de Barcelona. It discusses when extrinsic incentives are more or less likely to alter behaviors in the desired directions, focussing on incentives in education, incentives for 'pro-social' behaviour, and incentives and lifestyle habits. They argue that although "incentives to modify behavior can in some cases be cost effective", there is also a danger that direct extrinsic motivations might 'crowd out' intrinsic motivations. For example:

...an incentive for a child to learn to read might achieve that goal in the short term, but then be counterproductive as an incentive for students to enjoy reading and seek it out over their lifetimes.

The authors conclude:

Our message is that when economists discuss incentives, they should broaden their focus. A considerable and growing body of evidence suggests that the effects of incentives depend on how they are designed, the form in which they are given (especially monetary or nonmonetary), how they interact with intrinsic motivations and social motivations, and what happens after they are withdrawn. Incentives do matter, but in various and sometimes unexpected ways.

To paraphrase Sergeant Esterhaus: Choice architects, let's be be careful out there!

Is divorce such a disaster for kids?

Philip Larkin may have written that your mum and dad f*%k you up. But what, specifically, about divorce? The British tabloids regularly run features lamenting the "devastating" consequences of divorce on the "tots". But a recent paper by Shirley Liu from the University of Miami undermines some of those assertions.

Her paper, Is My Parent’s Divorce to Blame for My Failure in Life? A Joint Model of Child Educational Attainments and Parental Divorce (PDF), finds - like other research in the field - that children of divorced parents tend to have lower educational attainments. But is this caused by parental divorce?

Using annual data on a representative sample of children and their families since childbirth until the completion of their schooling, we model child’s schooling attainments and parents’ marital dissolution as joint decision processes, where unobservables triggering divorce and affecting child development are assumed to be correlated. After accounting for both observed and unobserved characteristics, we find no evidence that the lower educational attainments is attributable to parents’ divorce per se, but rather due to unobserved factors that are correlated with divorce.

...While further research is into the mechanisms through which parents’ divorce affects child attainments is needed, our findings provide some evidence that divorce in itself does not negatively affect children’s educational outcomes. The reasons for dissolving a marriage tend to be family-specific and usually observed only by the parties involved. Assuming that parents are altruistic and internalize potential gains (and costs) of dissolving their marriage on their children when deciding to divorce, on the margin there may be benefits to divorce (at least for some).

What implications for politicians and policy makers then?

If our goal is to help children from divorced families to become self-reliant adults, policy-makers need to be mindful that divorce in itself may be a consequence, rather than a culprit, of the same underlying mechanism that causes the inferior child outcomes. Simply restricting access to divorce without consideration of individual needs and circumstances can be irresponsible; it may also risk jeopardizing the welfare of many families and their children.

The 'family über alles' crowd won't like that.

UPDATE:
Undercover economist Tim Harford links to this post on his newish FT weblog, adding:

Are divorce lawyers worth the money?

Not according to an Austrian study presented at the recent EALE 2007 annual conference. Martin Halla's paper, Divorce and the Excess Burden of Lawyers (PDF), examined the divorce strategic game:

..we formulate a simply model where divorcing spouses can choose to hire a lawyer in their divorce process. A lawyer may affect the division of matrimonial property independent of the facts. We show that spouses encounter incentives as in the classical prisoners’ dilemma: Despite the zero sum nature of the game and their cost, each spouse has a clear incentive to hire a lawyer. In fact, if the expected benefits from hiring a lawyer outweigh the associated cost retaining a lawyer is a dominant strategy. We propose a simple institutional setting allowing for joint lawyers that facilitates to overcome this socially ineffcient situation and enables a second-best solution.

One can understand the dillemma faced by divorcing spouses. But what difference did hiring lawyers actually make to the outcome? Clearly the decision to hire a lawyer is non-random; one would expect divorcing spouses with less amicable relations to be more likely to pursue legal recourse. Yet the Austrian experience is that many spouses incur substantial lawyer fees without any gain in the division of matrimonial property:

This model is estimated and tested with data from court records. It turns out that in general there is no causal effect of the involvement of lawyers on the division of matrimonial property: Therefore, many spouses incur substantial lawyer fees without any benefit. There exists also no benefit of the engagement of lawyers in terms of more sustainable divorce settlements over time. On top of that lawyers prolong the divorce process. This excess burden of lawyers increases both private and public cost of divorce.

The policy implications are clear:

In order to overcome this worst case we suggest to tune the institutional setting in a way that as many of these couples as possible choose to hire a joint lawyer. A joint lawyer does not alter the divorce settlement either, (should) charges a lower fee and most importantly does not unnecessarily delay the divorce process.

Is this the case elsewhere, or unique to Austria? I would be interested in studies on the impact of lawyers on divorce settlements in other countries, such as the UK and United States. There's probably a paper here for the prolific Justin Wolfers and Betsey Stevenson team.

Libertarian paternalism: pro and con

With behavioural economics all the rage, it it was only a matter of time before we saw a backlash against 'libertarian paternalism', aka 'soft paternalism'. The Economist blog Free Exchange has a go: I'm your new legislator, but you can call me "Daddy"

THE field of Behavioural Economics has brought forth a new stepchild:  "libertarian paternalism", or "new paternalism".  The brain child of law professor Cass Sunstein and famed behavioural economist Dick Thaler, the basic idea is that because various cognitive errors cause us to make decisions that are at odds with our "true" preferences, companies, and perhaps the government, should set operational parameters on our lives that nudge us towards realising those true preferences. 

The most famous example of this is 401(k)s, the American tax-advantaged savings programme administered through companies.  Most companies had made the default that people weren't enrolled, for liability reasons.  It turns out, however, that this substantially lowers participation rates.  Since the plan has to have some default, Messrs Thaler and Sunstein argue, why not make it a modest contribution, say 5%?

I attended a fascinating luncheon at the Cato Institute today at which Mario Rizzo, a professor at NYU, denounced this idea in no uncertain terms.  In part, because it too easily shades into the old kind of paternalism.  We might start by arguing that cafeterias should be required to put the fruit displays before the trays of sweets (which evidence shows causes more people to choose a healthy dessert), because after all, the fruit has to go somewhere.  But then why not require them to order the healthier sorts of cakes?  After all, they can't order everything, so why not "nudge" those choices?

But he also challenged the notion that there are "true" preferences that should supercede our temporary ones.  The behavioural economics arguments generally rest on our faulty timebinding skills.  The "true" self--the one that has duration in time, as well as space--would like to be thin, well excercised, happily married, and loaded up with retirement savings.  But unfortunately, it delegates responsibility to the temporary self, whose brain chemistry has been programmed by evolution with overwhelming signals to indulge now!

It's not clear, however, what that means.  Is the true self something more than the sum of the temporary selves, all of whom enjoyed indulgence more than austerity?  Our brain systems seem obviously programmed with hordes of desires that fight against a bourgeois economic, moral and social system that values thrift and moderation in all things.  But those brains, with their various interlocking ad hoc subsystems, are, self-wise, all we've got; I'm not sure it's meaningful to try to discuss preferences as if they could somehow exist apart from the admittedly imperfect devices we use to generate desires, such as our dopamine reward networks.

That said, some of the professor's critiques are too strong.   Behavioural economics has shown people having different responses to rewards that are mathematically identical, depending on how the question is asked. That should not be; and to the extent that we think we can tell that one answer or another is better in a majority of cases, it's not ridiculous to think that we might want to carefully choose how we ask those questions.  Of course, we'd also want to ask how the deciders are overcoming those cognitive biases the rest of us suffer from.

Entertaining copy - but somewhat unfair. For an explanation and defence of libertarian paternalism see:

• Cass R. Sunstein and Richard H. Thaler, Libertarian Paternalism is Not an Oxymoron. University of Chicago Law Review 70 (4), 2003, pp 1159-1202.
• Richard H. Thaler and Cass R. Sunstein, Libertarian Paternalism (PDF) The American Economic Review  93 (2), 2003, pp 175-17

And from Mario Rizzo see:

• The Problem of Moral Dirigisme: A New Argument Against Moralistic Legislation, NYU Journal of Law & Liberty, 2005

I harbour no major concerns with the libertarian paternalist approach. Trying to correct for consumer or investor myopia, information asymmetries, well-established cognitive failings etc through structuring incentives and choices differently is surely in most cases preferable to the main alternative - greater regulation or higher public spending.

In any case, the scope for libertarian paternalism to reshape public policy has been exaggerated both by friend and foe. It's an interesting approach, to be sure - but no panacea for many social and economic ills. Let's not get carried way by the hype. 

Learning from sociology

As a partial mea culpa to Will, a link to a post from the orgtheory.net website: what economists should learn from sociology (hat tip: Tyler Cowen).

I was giving a talk about my research on the politics of the anti-war movement at the GMU econ department’s public choice seminar. At lunch, my good friend Bryan Caplan and his colleague Ilea Rainer asked me: what are five things that economists should learn from sociology? We didn’t get through all five, but here are three that came up:

1. Sociologists have a deep appreciation of imitation and conformity as a basic feature of human behavior. Economists rarely model this explicitly. If it is so important, as sociologists have shown, then economists are really missing the boat.
2. Social networks/social structure matters. Simple idea but few economists sit around and model the effects of social structure. Usually the best you get is a recognition that “norms” matter. My argument is that economists should care because social structures produce opportunities (e.g., you hear about jobs through networks). Most models assume that information/resources are out there but few wonder or model how networks/institutions create them.
3. Collect some real data. Most economists are “data downloaders.” They are afraid to get out there and survey or observe people, which limits your questions to what major data sets have asked. Experimental work is an improvement, but it is still a highly artificial construction. Go out and observe some markets with your eyes and get your hands dirty. Live a little!

What would you add?

See also my previous post: "The economy is social". Discuss

How should immigrants be integrated into the labour market?

The OECD has published four new Social, Employment and Migration Working Papers which provide accounts of how Germany, Sweden, Australia and Denmark have have handled their post-war migrant intakes. Each have different histories and policy responses, and while none could be considered an unequivocal success, Australia seems to have done better than most. The Danish government has actively promoted integration but employers appear to treat even the children of OECD immigrants badly. Sweden is still stuck with the legacy of the scarring effect the 1980s economic crisis, while Germany faces high levels of inactivity amongst Turkish women and a 'second generation' problem. Here are long excerpts from the executive summaries:

No. 47. The Labour Market Integration of Immigrants in Germany (PDF) by Thomas Liebig

Germany is currently in the process of a major restructuring of its complex integration framework. Under the new Immigration Act which came into force on 1 January 2005, there is a uniform introduction programme for all permanent immigrants.

As in the past, integration services focus largely on language training. There is little evaluation with respect to the effectiveness of this kind of training and it is generally not linked to labour market needs. Indeed, the scarce empirical evidence suggests that language training in Germany may not be very effective as a means of labour market integration. In addition to the regular integration services, there is a multitude of innovative projects. However, these are often locally-based and time-limited, and seldom designed in a way that would enable proper evaluation.

With respect to employment and unemployment rates, and particularly given their low educational attainment and the current economic situation, the labour market integration of immigrant men is relatively favourable in international comparison. However, immigrant women, and particularly those of Turkish origin, have very low employment rates. This is partly an outcome of policies which limited the labour market access of spouses. Most of these legal obstacles have been removed under the new Immigration Act.

The situation of the so-called “second generation” is of concern, as they have very low educational outcomes. This hampers their access to vocational training, which appears to have an even stronger impact on their employment prospects than on those of natives. The low educational attainment of the second generation seems to be at least partly attributable to structural features in the German education system, such as the early streaming which puts migrants’ children in a lower track. Especially problematic is the relatively late starting age for kindergarten and the prevalence of half-day education in kindergarten and school, which limits exposure to the German language at a crucial age. Immigrants’ access to self-employment is hampered by legal obstacles and a lack of information and subsequent access to financial credits.

Despite positive experiences with temporary employment as a labour market integration tool for immigrants in other OECD countries, immigrants are not a focus group of the Federal temporary employment programme.

No. 48. The Integration of Immigrants into the Labour Market: the Case of Sweden (PDF) by Georges Lemaître

The past fifteen years have seen a higher share of humanitarian migration in Sweden than in the past. This is a form of migration for which labour market integration appears to be slower than for other forms of migration in all countries. At the same time there has been a growing diversification of migration away from “Western” countries to those with a greater cultural distance.

With 1985 came the introduction of social assistance for refugees for an eighteen-month introductory period, the transfer of responsibility for integration away from the Labour Market Board and the refugee dispersal policy in which refugees were assigned to municipalities throughout Sweden to relieve the pressure on the large agglomerations, with local economic conditions not always being taken into account. The dispersal policy had a negative effect on immigrant outcomes, particularly with respect to those arriving during the economic crisis, for whom the effects seem in many cases to be persistent.

With the severe economic crisis of the 1990s, asylum seeking in Sweden continued and those asylum seekers that were recognised and granted a residence permit were met with a labour market situation that was highly unfavourable and where considerable numbers of native-born Swedes with domestic formal qualifications and work experience were also looking for work. At the same time, the crisis struck immigrants already present and employed disproportionately. The re-integration of immigrants into the ranks of the employed was rendered all the more difficult by the fact that some two-thirds of jobs, in the Swedish labour market appear to be filled through informal methods.

The situation of immigrants has improved significantly since the trough of the economic downturn, especially for new arrivals. The relatively favourable impact on employment of a minimum amount of language training and of vocational training for this group and the relatively low take-up of these suggest that there is room for improvement with regard to labour market outcomes in the early years of residence, which can be expected to persist with continued residence.

The situation for immigrants having arrived since the mid-eighties and having suffered the brunt of the economic crisis of the nineties remains unfavourable. It is difficult to see how the continuing employment problems of this group can be turned around without a strong economic expansion, given the re-enforcing nature of further non-employment on both inactivity and employer perceptions. If targeted measures are politically infeasible, then general measures that provide especially favourable results for immigrants need to be encouraged and expanded.

...What employers recognise and reward seems to be Swedish work experience and successful integration tends to be associated with early contact with the labour market. Results seem to suggest that the benefits of early employment experience on later employment are much stronger than those of Swedish vocational education. Improving the efficiency of language instruction so as not to overly prolong labour market entry and ensuring that proficiency requirements reflect actual occupational needs are matters of some importance.

No. 49. The Labour Market Integration of Immigrants in Australia (PDF) by Thomas Liebig

Overall, the labour market integration of immigrant men in Australia can be considered to be relatively favourable in international comparison. This is partly attributable to selection policy and the prevalence of the English language in many parts of the world. Even with similar socio-demographic characteristics, skilled migrants tend to perform better than other migrant groups. In contrast to the positive outcomes for immigrant men, the labour force participation of immigrant women is not high in international comparison.

Happiness in Whitehall

Whitehall has been looking at happiness and well-being, according to the Sunday Times, citing a new 193 page Defra report Review of research on the influences on personal well-being and application to policy making (PDF) by Paul Dolan and Tessa Peasgood from Imperial College London and Mathew White from the Centre for Well-being in Public Policy, University of Sheffield. John Elliott writes in his piece, Happiness is a chat over the fence, that:

The attempt to quantify what the report calls “SWB” — a personal “sense of wellbeing” — is part of a move by all the main political parties to go beyond purely financial measures of wellbeing in setting goals for policy.

The Whitehall Wellbeing Working Group (W3G for short), a committee of civil servants, has been charged with finding out how ministers can make citizens more cheerful. The report was commissioned by the environment department, which is leading the Whitehall effort. It consists of a review of research carried out around the world into the factors influencing happiness and how governments can affect it.

But what does happiness research mean for policy makers?

“It’s shown that married people are happier — so what does that mean for politics? Does it follow that we should be encouraging people to marry?” asked Dolan, whose next task for the government is to draw up a reliable “happiness unit” to measure wellbeing. He added: “Is that the realm of politics . . . or something that should be left to individual choice?”

While the idea of a Whitehall-defined unit of happiness may not fill that many people with joy, its supporters hope that by pinpointing what makes people happy, taxpayers’ money could be spent with greater effect on national wellbeing.

“If the aim of policy were to alleviate misery, there may be some justification for targeting women as they tend to exhibit higher levels of depression.”

...Although the government has not yet reached many specific conclusions, the health department is working on advice to primary care trusts on promoting wellbeing. The environment department added that the transport and culture ministries were also “interested” in measuring how their policies affected people’s happiness. Meanwhile, the Department of Trade and Industry has just launched a two-year research project into “Mental Capital and Wellbeing”, which, said Defra, “aims to produce a challenging and long-term vision that maximises mental capital in the UK in the 21st century for the benefit of both individuals and society”.

Simon Parker, head of public services research at the think tank Demos, welcomed the new emphasis on wellbeing. He said: “You are starting to see politicians talking about issues that reflect how life isn’t just about cash . . . but it’s important to inject a note of realism, there is only a certain amount a government can do.”

Of course, not everyone is enamoured. Times columnist Libby Purves (In Grey Britain it's always your fault, 9 January) is just back from abroad and thinks it all quite banal:

The latest political buzz is a “wellbeing index”, masterminded by 3WG, the Whitehall Wellbeing Working Group, whose civil servants now have a report in their hands commissioned by the Department for the Environment. It reveals that people are happier if they get plenty of sleep and a social life, are not too fat and get promotion at work; and that they get unhappy if they are jilted, sacked or soaked by heavy rain.

With discoveries as startling as this, it cannot be long before another costly Whitehall survey finds that our wellbeing suffers when we are treated like pointless nuisances by services and authorities that we are paying for.

A tad unfair. The report itself provides a very useful review of the literature and discussion of the various measures of subjectve well-being and their relative merits. For anyone researching this area, it's a must read.

Germany's baby bonus

People respond to incentives - even expectant mothers. We know from Andrew Leigh and Joshua Gans' recent paper, for example, that Australia's 'baby bonus' resulted in over 1,000 births being moved from late June to early July 2004, mostly via fewer C-sections and inducement procedures.

It looks like Germany is experiencing a similar effect, as expectant German mothers delay giving birth to cash in on benefits. Today's Scotsman reports:

Heavily pregnant German women are going to extreme lengths to delay giving birth until 1 January 2007 - because a new law will mean a difference of tens of thousands of pounds in benefits.

Parents of babies born in Germany on or after January 1 will benefit from generous new family subsidies. Consequently, all sorts of tips about keeping baby at bay are being traded on the internet, in magazines and in family planning classes.

"From Christmas onwards, I have been standing on my head," said expectant mother Antje Grimm. "I have heard that is one way to stop the child from becoming too overactive while not harming it."

Under the new Elterngeld, or "parents' money" law, parents who stay home to look after the newborn child will receive 67 per cent of their last net income tax free, or up to 1,800 - more than £1,300 - a month, for the first 12, or in some cases 14, months after the birth.

The already affluent, in particular, will be significantly better off. Currently, parents whose annual net income lies below a certain level - 30,000 per couple - can choose between up to 24 monthly payments of up to 300 or 12 monthly payments of up to 450.

...the motivation behind the plan to get Germans reproducing is based on sheer pragmatism: the German birth rate has fallen to an average of 1.3 children per woman - far lower than the 2.1 children per family replacement rate needed in industrialised countries. The Federal Statistics Office has ominously forecasted a drop in the population from today's 82 million people to just 69 million by 2050 - a decline it warned "cannot be halted".

That kind of demographic implosion would spell disaster for the country's creaking pension system. The shrinking population could also result in a shortage of skilled workers and lack of innovation.

German politicians hope the legislation can help reverse that trend.

Though the law may help in the long run, it has expectant mothers in their last days of pregnancy feeling a bit anxious. In recent weeks, soon-to-be parents have inundated doctors and midwives for advice on how to prolong pregnancy.

Labour takes stock

The Prime Minister's Strategy Unit published a presentation on its website yesterday. Strategic Priorities for the UK: The Policy Review (PDF) is described as "background for Cabinet discussion of the policy review programme on 19th October 2006". It's quite an interesting, albeit discursive, overview of what the government sees as its key achievements and challenges. Economics editor Larry Elliott summarises the economic material in today's Guardian:

Tony Blair and Gordon Brown believe the economic stability the government has presided over since 1997 is a necesssary but insufficient condition for the big challenge of the next decade - tackling the threat posed by the big emerging economies of China and India.

Over the past decade and a half, the size of the global labour force has doubled to three billion as a result of the collapse of communism in the Soviet Union, China's embrace of the market and the arrival of India as a global economic force.

With the fast-growing developing economies having far lower levels of wages than those in the UK, Labour says the only option is a "knowledge economy" which specialises in sectors such as pharmaceuticals, biotechnology, environmental protection, nanotechnology and financial services.

These are areas where the UK has a tradition of strength, where the profits margins are high, and where the competition from India and China has so far been less evident than in low-cost manufacturing.

Labour has identified two areas that need to be addressed. The first is ensuring that Britain can compete in the lucrative high-skill sectors, where there is some concern that the UK spends less on research and development than its main rivals; that Britain's level of skills compares badly to those in the United States, Germany and Japan; and that the flow of new scientists may be drying up.

Although the government says educational standards have been rising, there are 7 million adults who are unable to read and write. At the other end of the spectrum, the number of undergraduates reading the physical sciences, engineering and technology has been falling, while fewer children have been taking maths and science at A-level.

The government's second concern is to ensure that growth benefits all groups in Britain. Labour admits the very poorest have not shared the benefits of growth, while inequality is more pronounced than it was in 1997.

Danish for all? No thanks, says IMF

We know that the European Commission, the OECD, the World Economic Forum and the World Bank all think very highly of Denmark. But what about the IMF? The Executive Board are quite positive in their latest Article IV consultation with Denmark. Yesterday's Public Information Notice states:

Directors noted that the Danish flexicurity model has worked well, contributing to Denmark's low unemployment. At the same time, they observed that it involves costly benefits and active labor market policies, which may make it less applicable to countries with high unemployment and weak public finances. Nonetheless, the model merits study by other countries, as a possible way to increase labor market flexibility.

However the accompanying report, Denmark: Selected Issues, is not quite as fulsome. It contains a 22 page paper by IMF economist Jianping Zhou entitled Danish for All? Balancing Flexibility with Security: The Flexicurity Model. The concluding remarks start off pleasantly enough:

The Danish flexicurity model has been widely praised for its association with a low unemployment rate and a high standard of social security for the unemployed. The model combines a high degree of labor market flexibility with a high level of social protection. While most European countries are facing chronically high unemployment rates and the needed labor market reforms often face strong political opposition, the flexicurity model looks increasingly attractive to policymakers in Europe. (emphasis in the original)

But then point out some of the potential problems in adopting the flexicurity model:

However, whether the Danish model should and can be adopted by other European countries to reduce unemployment is not obvious. First, Denmark has traditionally had a combination of a flexible labor market and a high level of income protection. Economic performance under this system has varied, as demonstrated by the economic crisis during the early 1980s and the remarkable labor market performance in recent years. Second, other countries have been able to reduce their high unemployment rates to low levels with rather different social models (e.g., Ireland, Sweden, and the United Kingdom). Finally, generous unemployment benefits often raise moral hazard issues that might hinder effective implementation of the Danish model. In this regard, a strict job search requirement and tight eligibility criteria for unemployment benefits are key.

The Danish model is costly. The tax burden in Denmark is heavy because of the need to finance the country’s high spending on labor market programs and unemployment benefits. As most countries that are tempted to adopt the Danish model will typically start from a high unemployment level, a move toward the Danish model will, in the short run, trigger a sharp increase in the cost of unemployment benefits and active labor market policies, thereby widening the tax wedge, with an adverse impact on labor demand and supply. This implies that the Danish model may not be suitable for countries facing high unemployment and budgetary difficulties. Using a calibrated model for France, the paper finds that implementation of the flexicurity model could be costly, and reduction in structural unemployment during the first few years might be limited.

Nonetheless, certain key aspects of the Danish model could usefully be studied and considered by other countries...

So the countries which could benefit the most from a more flexible labour market - those with high unemployment - would face high up-front costs and at best modest short-term reductions in unemployment were they to move to the Danish model. That's why the Danish (or Swedish or Dutch) model has not spread more widely - few politicians are prepared to bear the short-term fiscal and political cost for medium-term gains that may not occur until after they've left office. Gerhard Schroeder is a notable exception - and Germany is now starting to see unemployment rates fall. But how many other European politicians would dare follow his brave example?