Wednesday, June 28, 2006

Behavioral Economics

A reader asks about hot topics in economics:
What have been the most important theoretical papers/breakthroughs in the last 10-15 years? New growth theory is now getting quite old and while there are plenty of hot topics empirically, theory seems to have died down since the 1980s. Am I missing some important developments?
The reader is correct that the new growth theory ran into diminishing returns--as everything eventually does.

Without doubt, the next hot research topic after new growth theory, at least here in Cambridge, has been behavioral economics, which integrates economics and psychology. You can find a good introduction to this research in Harvard Magazine. To many economists, the rise of behavioral economics is old news, but readers unfamilar with the topic will enjoy the article. Even more recently, those working in this area have taken the next step of integrating brain science to create a new subfield called neuroeconomics. (Note to incoming Harvard students: David Laibson will be giving an ec 10 lecture on these topics in the fall.)

Research on behavioral economics has promise for providing new perspective on public policy. Here is a new case study from the sixth edition of my intermediate macro textbook:

Case Study
How to Get People to Save More

Many economists believe that it would be desirable for Americans to increase the fraction of their income that they save. There are several reasons for this conclusion. From a microeconomic perspective, greater saving would mean that people would be better prepared for retirement; this goal is especially important because Social Security, the public program that provides retirement income, is projected to run into financial difficulties in the years ahead as the population ages. From a macroeconomic perspective, greater saving would increase the supply of loanable funds available to finance investment; the Solow growth model shows that increased capital accumulation leads to higher income. From an open-economy perspective, greater saving would mean that less domestic investment would be financed by capital flows from abroad; a smaller capital inflow pushes the trade balance from deficit toward surplus. Finally, the fact that many Americans say that they are not saving enough may be sufficient reason to think that increased saving should be a national goal.

The difficult issue is how to get Americans to save more. The burgeoning field of behavioral economics offers some answers.

One approach is to make saving the path of least resistance. For example, consider 401(k) plans, the tax-advantaged retirement savings accounts available to many workers through their employers. In most firms, participation in the plan is an option that workers can choose by filling out a simple form. In some firms, however, workers are automatically enrolled in the plan but can opt out by filling out a simple form. Studies have shown that workers are far more likely to participate in the second case than in the first. If workers were rational maximizers, as is so often assumed in economic theory, they would choose the optimal amount of retirement saving, regardless of whether they had to choose to enroll or were enrolled automatically. In fact, workers' behavior appears to exhibit substantial inertia. Policymakers who want to increase saving can take advantage of this inertia by making automatic enrollment in these savings plans more common.

A second approach to increase saving is to give people the opportunity to control their desires for instant gratification. One intriguing possibility is the “Save More Tomorrow” program proposed by economist Richard Thaler. The essence of this program is that people commit in advance to putting a portion of their future salary increases into a retirement savings account. When a worker signs up, he or she makes no sacrifice of lower consumption today but, instead, commits to reducing consumption growth in the future. When this plan was implemented in several firms, it had a large impact. A high proportion (78 percent) of those offered the plan joined. In addition, of those enrolled, the vast majority (80 percent) stayed with the program through at least the fourth annual pay raise. The average saving rates for those in the program increased from 3.5 percent to 13.6 percent over the course of 40 months.

How successful would more widespread applications of these ideas be in increasing the U.S. national saving rate? It is impossible to say for sure. But given the importance of saving to both personal and national economic prosperity, many economists believe these proposals are worth a try.