Behavioral law and economics has arisen to international prominence; between Cass Sunstein’s appointment to head the Office of Information and Regulatory Affairs the United Kingdom’s appointment of a “nudge” bureau, behavioralism has enjoyed a meteoric impact on policymakers.  Thus far, behavioral economists have almost exclusively focused on the myriad foibles or purported cognitive errors which hamper consumer decision-making.  These traits include “optimism bias,” the tendency for an individual to underestimate the likelihood of negative results from their behavior, and hyperbolic discounting, where individuals reveal time-inconsistent preferences (often by over-valuing immediate consumption, at least as measured against some third party’s valuation).

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We would like to start by thanking Josh for inviting us to participate in what promises to be a fascinating discussion on an important subject.  We’re looking forward to engaging with the other members of the symposium.

To begin with, we would like to talk about some of our own experimental research on the valuation anomaly widely known as the “endowment effect.”  Over the past quarter century, laboratory and field research in the social sciences has provided considerable evidence for the existence of a significant gap between the valuations that people attach to goods that they own and the valuations they attach to goods they are considering purchasing.  Thus, in one classic and well-replicated study, subjects to whom a university coffee mug was given indicated substantially higher willingness-to-accept values than subjects who indicated their willingness-to-pay for the mug.  This and similar studies suggest that aspects of goods that should be irrelevant from the perspective of neoclassical economics – such as the fact of prior ownership – can systematically bias valuations of those goods and lead to sub-optimal exchanges and inefficiencies.

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Behavioralism is mesmerizing.  Ever since I took Cass Sunstein’s outstanding Elements of the Law course as a 1L at the University of Chicago Law School, I’ve been fascinated by studies purporting to show how humans are systematically irrational.

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The problem with behavioral law and economics (and its behavioral economics cousin) is not that it has nothing interesting to say, but rather that the interesting things it has to say do not mean what its proponents think they mean.  It is one thing to claim that people are less rational than we thought.  It even one thing to claim that people are systematically less rational than we thought, in predictable and important ways.  But it is entirely another to presume that the implication of this is a larger scope for government regulation to protect the market and market actors from the depredations of this irrationality.

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I thought I’d aim my opening post at the question that motivated my interest in this symposium:  is behavioral economics leading us to the end of free markets and the takeover of the regulatory state?

Consider how far we’ve come since the days of “caveat emptor,” when sellers had a legal right to fool and cheat buyers, and consumers were free to be fooled and cheated.

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Behavioral economics: love it or hate it – there seems to be no middle ground. Lovers take the obvious fact people are not frictionless maximizing machines together with the false premise that economists assume that they are to conclude that all of economics must be wrong. The haters take the equally obvious fact that laboratories are not the real world to dismiss all laboratory evidence that conflicts with their pet theories as irrelevant. In the end they seem primarily to talk past each other.

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I have long argued that the economic assumption of rationality is useful not because it is a complete and correct description of real world behavior but because it describes that part of behavior that is predictable. If half the time an individual takes the actions that best achieve his goals and half the time he acts at random, then modeling his behavior as rational with some random error probably does as good a job of predicting it as we can do. When dealing not with a single individual but with the aggregated affects of many individual actions, random actions will tend to cancel out, making the predictions of a rational actor model more accurate than they would be for a single actor. Further, in some but not all cases, the actors that most matter are precisely those selected for successful decisions in the past—successful speculators, for example, have more money to speculate with and so a larger effect on markets, than unsuccessful ones.

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A federal district court judge recently decided an interesting antitrust/ IP case involving “wheel game” slot machines.  IGT sued Bally’s in 2004 for allegedly infringing a number of patents on a “wheel game” slot machine.  Bally’s initially prevailed, winning a pair of summary judgment rulings on the validity of IGT’s patents and refusing to grant summary judgment on Bally’s antitrust counterclaims.

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Today comes news that Senator Kohl has sent a letter to the DOJ urging “careful review” of the proposed Google/ITA merger.  Underlying his concerns (or rather the “concerns raised by a number of industry participants and consumer advocates that I believe warrant careful review”) is this…

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