Behavioral Public Finance

Chapter 5. Mispredicting Utility and the Political Process

Chapter 5 Mispredicting Utility and the Political Process BRUNO S. FREY AND ALOIS STUTZER I ndividual decisions involve difficult trade-offs between pursuing material wealth, status, and fame on the one hand and, on the other, investing in social relationships and choosing activities that provide autonomy and the experience of competence. There is an increasing belief that people systematically err in these decisions and spend too much time, effort, and money on goods, services, and activities with strong extrinsic attributes (Scitovsky 1976; Frank 1999; Easterlin 2003; Layard 2005). We argue that this tendency is attributable to systematic misprediction of utility. When people make decisions, they mainly take salient extrinsic attributes of choice options into account. They thus overvalue characteristics relating to extrinsic desires such as income and status and underestimate those relating to intrinsic needs such as time spent with family and friends and on hobbies. It follows that they tend to underconsume goods and activities with strong intrinsic attributes. According to their own evaluations, people make distorted decisions when they choose between different options and obtain a lower utility level than they otherwise would. They find comparisons between attributes whose salience shifts over time difficult to make, so that learning is severely hampered. People are, however, to some extent aware of their tendency to mispredict . They complain, for example, about their work-life imbalance and that they cannot manage it in their day-to-day decisions. In this chapter, we analyze whether the political process helps people mitigate biased decisions attributable to misprediction or accentuates 113 114 Behavioral Public Finance them. Scholars dealing with biases in decision making related to the misprediction of utility usually disregard this aspect. We distinguish among four types of government to study government reactions to people mispredicting utility. We then identify public discourse as the key to people’s learning in the political process and to adopting precautionary policies. Possible policy interventions that reduce biases attributable to misprediction are discussed as an input to the political discourse process. We then pose two sets of empirically testable propositions. Individual Decision Making when Utility Is Mispredicted Standard economic theory assumes that individuals are able to compare future utilities provided by goods and activities consumed. They maximize the utility in a rational consumption decision. In certain cases, it has proved useful to distinguish between the various characteristics of goods and activities (Lancaster 1966; Becker 1965) or the attributes of options (for example, Keeney and Raiffa 1976). This differentiation is not, however, taken to affect the evaluation of future utility. The utility of a chosen combination is simply the sum of the weighted value of each characteristic Options with Changing Salience of Attributes The standard economic model of consumer decisions is appropriate for most goods and activities, and for most situations. It is still appropriate when individuals make random prediction errors, or when the extent of misprediction is the same for all goods and all activities. Here we depart from these assumptions to argue that there are systematic differences in mispredictions between two types of attributes characterizing different options.1 Attributes of the first type relate to intrinsic needs. Edward Deci and Richard Ryan’s self-determination theory provides a comprehensive view of three main needs (2000). First, there is a need for relatedness, to feel connected to others by love and affection—that is, having a family and friends and being in a social setting. Second, there is a need for competence , to control the environment and experience oneself as capable and effective. Third, there is a desire for autonomy, the experience of being in charge of one’s actions or being causal.2 Intrinsic attributes are also characterized by providing “flow experience” (Csikszentmihalyi 1990), that is, when one is completely immersed in an activity, often a hobby. The second type of attributes relates to extrinsic desires and serves peo- ple’s goals for material possessions, fame, status, or prestige. Income thus becomes one of the critical attributes of options in the choice set. Each option, activity, and even good is multidimensional; in general, a particular choice alternative has both intrinsic and extrinsic attributes. But some goods and activities have a stronger intrinsic component (for example, time spent with friends),3 others a stronger extrinsic component (such as most consumer articles, which go beyond basic material needs). Work is particularly interesting. Having work gives people a strong sense of self-determination, and being...