Wednesday 17 August 2016

Irrational surplus

In 2009, Matt Burgess and I argued that irrationality isn't a reason for abandoning consumer surplus. If flaws in perceiving the cost of some kind of potentially risky consumption activity lead to overconsumption relative to a fully informed or fully rational norm, that means there'll be some excess cost associated with that level of consumption. 

The true marginal cost curve then lies above the perceived one, with the perceived one affected by, say, the consumer's preference to believe that he's less likely to suffer harm than the average person. Some in the public health crowd were trying to argue that the potential for irrationality meant we couldn't use consumer surplus anymore. We showed instead that it might imply more consumption than the person would find optimal, but that just gives us an excess burden equivalent to the red area. You could benefit those consumers by encouraging them to shift to the left a bit, but that's hardly the same thing as saying they get no consumption benefits at all.

We got yelled at a bit for (in others' views) not being sufficiently cognisant of the behavioural lit which (in my view of their view) means anything goes and welfare economics disappears.

Levy, Norton and Smith take on consumer surplus in tobacco cost-benefit assessment in July's set of NBER working papers. They provide a behavioural welfare economics where consumers might overconsume a bit due to some irrationality. They argue that the optimal tax in that context, for a biased consumer, puts in place a price wedge equivalent to the consumer's overestimate of the benefits of consumption. 

So the consumer whose biased view leads him to a demand curve of Db, where an unbiased one would have Du instead, can be made better off by t* bridging the gap; in the absence of that, you'd have deadweight costs of the same size, represented by the triangle bounded by P+t, Db, and Q0. 

Either way, consumer surplus remains the best framework for analysis. And their behavioural welfare graph - same deal as Matt and I argued in '09. I'm not trying to make any priority claim here - this is just bog standard "what is totally implied by intermediate microeconomics" stuff. 

In Appendix Figure 3B, they also show the analytics where taxes are above the optimal level with biased consumers. As you'd expect, there's a welfare gain from the first bits of reduced consumption, followed by welfare losses that increase in the the deviation of the actual tax from the optimal tax. 

I particularly liked this part:
A third implication is that we can rely on consumer surplus calculated using the unbiased demand curve for welfare analysis, because the unbiased demand curve reflects the value that fully informed and rational consumers place on different aspects of well-being (e.g., their own health versus the enjoyment from smoking). In particular, it is not necessary to calculate the health gains of a particular policy and then calculate an offset for foregone enjoyment; it is sufficient simply to look at changes in consumer surplus. 
They conclude:
Even if consumers are not rational, the correct response from an economic perspective is not to abandon welfare analysis in favor of policies that maximize health; rather, it should be to figure out how to perform welfare analysis when consumers are not rational. We propose that health economists should embrace the behavioral welfare economics framework developed for this purpose, developed primarily with reference to environmental economics.

We acknowledge, however, the practical difficulty of implementing this framework. In particular, the behavioral welfare economics approach requires knowing the shape of not only the biased market demand curve, but also the shape of the hypothetical unbiased demand curve. This is a tall order. Once again, we propose drawing on the literature in environmental economics and behavioral welfare economics for inspiration (Allcott and Sunstein 2015; Chetty 2015; Mullanaithan et al. 2012). Researchers in this literature have for some time focused on the empirical question of identifying the extent of bias in consumer choices.
And it would get more fun where consumers vary in their deviation from rationality.

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