In this post I return to one of my favorite topics: Behavioral economics, and how we can use it to argue against leftist policies and in favor of a small government.

A while ago I read an excellent book – “The upside of irrationality” by Dan Ariely, a behavioral economist at Duke University who pretty much alone is the reason why so many non-academicians today are familiar with behavioral economics (though I’m doing my best to help him spread the word).

As usual, I admired Prof Ariely’s research. Reading a book by Dan Ariely really feels more like reading a detective story than a research paper – I always feel tempted to skip a few pages to find out what the result of the experiment he just described turned out to be.

However – and not for the first time – I didn’t really interpret the results the same way.

In chapter 6, Ariely writes about adaptation – how it is pretty much impossible to get permanently happier by buying something. Sure, buying a new car may make you happy for a while, but once the novelty wears off, your “everyday happiness” will return to its former level. If you want to be happier, Ariely tells us, you have to “surprise” yourself – once you get used to something, it can no longer make you happier. So, if you buy a new, better phone – keep your old phone and use it every once in a while, just to remind yourself of how much better your new one is. That way, your new phone can increase your happiness for longer than it otherwise would. I personally think that’s a great idea.

But there is another implication that Ariely doesn’t really talk about – in order to increase our level of happiness in the long term, we need improvements. A new, improved phone, for example. And in order for these (material – the others are outside the realm of economics) improvements to happen, we need growth. More specifically, we need technological growth – the type of growth that gives us iPhones, iPads, sliced bread and dishwashers.

And here’s the thing about technological growth: It doesn’t just happen. Sure, standard economic (Solow-swan) theory assumes that technological growth is “exogenous” (ie. it just happens for no particular reason) for the sake of simplicity, but it’s quite obvious that technological improvements are not going to happen at the same rate in every country – there is a reason why the iPhone was invented in the US, not Somalia.

Without technological improvements, we cannot grow at all in the long term. Sure, we can get short-term growth by printing money, or medium-term growth by raising our savings rate – but in the long term, it all comes down to innovation.

Do you know what makes capitalism so awesome? It’s really really good at the whole “producing innovations that increase our living standard” thing.

And, it does so continously, every year. Therefore, we got to enjoy new innovations that – while none one of them will make us happier forever – will definitely make us happier for a while and will make our lives easier. Without these innovations, our average lifetime level of happiness would be significantly lower.

Most people would agree that having a market economy is better (from an innovation point of view) than having a controlled, planned economy. But studies (Acemoglu et al, 2012) actually show that “hard” capitalism is better than “soft” capitalism when it comes to producing innovations: Hard capitalism – meaning capitalism without the huge safety nets and overburdening regulations seen in much of Europe (and increasingly the US) – for some reason appears to be more efficient when it comes to encouraging people to take chances and innovate.

Basically, what this means is that the US is creating a disproportionate share of the world’s technological growth, which the rest of the world is then allowed to free-ride on: When something is invented, that innovation most likely won’t stay in the country it was invented in. So when America with it’s “hard” capitalism invents the iPhone, the iPhone won’t just stay in the US – in today’s global world, it only takes a few months or a year at most for an invention like the iPhone to travel around the globe. It goes even faster if the invention is a piece of software rather than a physical product. Hence, technological growth in one country (the one that invested and paid for it) turns into technological growth for EVERY country.

The technological growth in the free-riding countries (those in Europe) will then increase tax revenue. In other words, America’s hard capitalism is paying for Europe’s welfare states. Now that’s an irony if I’ve ever seen one.

OK, so this is unfair, but the worst part is that as the US moves towards a softer, European-style capitalism, that means that technological growth – and hence overall growth – will slow down GLOBALLY.

Is this too complicated to follow? Let’s just say that innovations make us happy, fewer innovations means we’re less happy, the US is producing a disproportionate share of the world’s innovation due to having an economic system that encourages innovation, but it is now slowly switching to another system with less innovation that will lead to everyone becoming less happy. Oh, and this switch will also hasten the demise of the European welfare states as they won’t be subsidized by American innovation any longer (so I guess something good may come out of it…).

If our happiness was determined merely by the level of wealth that we had, this wouldn’t really be a huge issue – our level of wealth in the western world is so high that the marginal utility (the additional happiness caused by a 1-unit increase or decrease) of money is really really low anyway. But, since we know from behavioral economics that what really matters is CHANGES in wealth, a decrease in the annual growth rate and the number of new innovations each year can have a serious impact on our overall level of happiness.

Moving on to another topic: Regulation – and why Behavioral economics doesn’t (necessarily) support that either

I could write an entirely separate post about this, but I figure I’m on a roll so why not just keep going…

How many of you have heard of the Rebound effect? Go ahead and google it if you like, otherwise it can best be explained by an example: You know how some (all?) people who buy a “green” car suddenly starts to drive a lot more than they used to? The car may go twice as many miles/gallon, but if you more than double the number of miles that you drive, then from an environmental point of view it would have been better if you hadn’t bought the car in the first place.

Essentially, when we do something good (buy a green car), we “compensate” by doing something bad (drive more). Similar things happen when we quit smoking (those who quit smoking are known to be prone to take up over-eating; replacing one bad habit with another), try to lose weight (taking up other unhealthy habits like smoking) or put on a safety belt (driving at higher speed, leading to the overall risk of dying from a car accident increasing).

What does this have to do with regulation?

See, regulation can also induce rebound effects – they may prevent us from conducting one type of destructive behavior, but there is really no way of predicting what other destructive behavior may occur as a result of the regulation that stopped us from conducting the first type of destructive behavior.

Seatbelt laws make us drive faster. Laws mandating bike helmets make us less careful when we cycle. Diets that force us to cut out one food group (carbs, fat) make us increase our intake of unhealthy foods from other food groups (ie those on low-carb diets often start eating extreme amounts of fat).

That’s how the rebound effect works, and that’s why nearly all regulations that try and prevent individuals from hurting themselves fail.

Take the recent (now overturned) ban on large sodas in NYC. Those who supported the ban pointed to studies that showed that consumption is sensitive to context: We eat more from large plates, we eat more when given a big spoon/fork, and we drink more from large bottles. I definitely agree with these studies –  preferences are volatile and not nearly as neat and stable as neoclassical economics assumes them to be.

However, what these studies do not show, is what effect preventing somebody who is used to drinking from large sodas from doing so will have on their overall consumption. The question on whether and in that case how they will end up “rebounding” is left unanswered. Perhaps, in a favorable scenario, these individuals would have simply bought two 16-oz sodas instead of one 32-oz. But more likely, a lot of obese new yorkers were going to think that “Since I’m no longer able to buy those 32-oz soda bottles, I definitely deserve an 8-oz bar of chocolate”. The problem, of course, is that an 8-oz bar of chocolate contains more sugar and calories than 16 oz of soda. And so, to stop this type of “rebounding”, NYC would soon have had to ban large chocolate bars, and then once the chocolate lovers decided to “rebound” by consuming something else unhealthy (potato chips?), they would have had to ban that product too. Unhealthy individuals who do not care about their bodies will always find a way to hurt themselves, with or without supersized sodas.

What it boils down to essentially is that if you’re stupid, you’ll always find a way to be stupid, and if the government prevents you from expressing your stupidity through one way, you’ll just find another way (that may be a lot worse).

The same can be applied to many other areas of regulation as well. Obesity is caused by a behavior that isn’t going away just because 32-oz sodas go away, just like sociopathic bankers aren’t going away just because the subprime mortgage market gets regulated (which isn’t to say that we don’t need any financial regulation, I’ve written about that before).

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I could go on about how these types of regulations also breed a type of mentality where citizens begin to think that everything that is legal is healthy (because they expect the government to ban everything that is unhealthy), but this post is long enough as it is so I’ll have to return to that topic another time.

Thanks for reading.

Photo credit: Gage Skidmore via Flickr (Attribution 2.0 generic)

2 comments
  1. Do you know what makes capitalism so awesome? It’s really really good at the whole “producing innovations that increase our living standard” thing….

    Amazing writing and insight there………. you should work for the Daily Mail!

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