1. Agenda as of 2/17 Today: A final word on behavioral economics Begin Climate Science Friday: No class Monday 2/22: Problem set 2 due Climate science and begin integrated assessment models Wednesday: Climate science and IAM Friday: review Monday, 3/1: hour test in class 1

2. Behavioral issues in energy and the environment Economics 331b Spring 2010 2

3. Background Major grounds for government intervention in energy and environmental markets: 1.Market failures (uninternalized externalities such as CO2 emissions, oil premium, …) 2.Behavioral failures (informational, decisional, etc.) 3

4. The challenge to mainstream economics Here are some issues of preference theory from standard economics that are challenged (from least to most damaging): 1.People have good information and/or process information efficiently (data competence) 2.People act to optimize their preferences relative to information and resources (decision competence) 3.People have self-interested preferences over consumption of goods, services, and capital (non-weird preferences) 4.People have well defined or stable preferences over goods and time (coherent/stable preferences) Behavioral economics challenges all of these. Important note: Behavioral failures are different from market failures! 4

5. 5 Economics after behavioral attack

6. Informational incompetence Classical: People have good information and/or process information efficiently Behavioral: People have all kinds of biases in structuring information (law of small numbers, overconfidence, anchoring, hindness bias) Examples of overconfidence effect: Second-year MBA students overestimated the number of job offers they would receive and their starting salary. Students overestimated the scores they would achieve on exams. Almost all newlyweds in a US study expected their marriage to last a lifetime, even while aware of the divorce statistics. Professional financial analysts consistently overestimated corporate earnings. Most smokers believe they are less at risk of developing smoking- related diseases than others who smoke. 6

7. Decision incompetence Classical: People act to optimize their preferences relative to information and resources Behavioral: People make all kinds of trivial and tragic mistakes in daily life Examples: 4 million unwanted pregnancies a year 37,000 traffic fatalities in 2008 Addictions (smoking, alcohol, …) Default option matters in pension decisions, organ transplants Refusal to lower the asking price on house because it is below the price you paid for your house? 7

8. Defaults matter for organ transplants Eric J. Johnson and Daniel Goldstein, “Do Defaults Save Lives?” Science, Nov 2003. 8

9. Weird (i.e., non-classical-economics) preferences Classical: People have self-interested preferences over consumption of goods, services, and capital (non-weird preferences) Behavioral: People are altruistic, care about fairness, will contribute to the public good, have spite. Examples: The ultimatum game: I start with $100. Then I keep X for myself and offer you $100-X take-it-or-leave it. Both parties agree for anyone to get anything. -Economics predicts solution is (100-ε, ε). -In fact, we see most often (50, 50). Moreover, (90,10) is often rejected by second party. Cooperation, fights, wars, strikes, … 9

10. Unstable/incoherent preferences Classical: People have well-defined and stable preferences over goods and time (stable preferences) Behavioral: People have status-quo bias, reference levels, adaption, loss aversion, hyperbolic discounting, uncontrollable passion or rage Examples: –The mug-ring experiment: I pass out 10 Yale mug and 10 Bulldog rings at random. Each costs $10. Then at the end of the class, I organize a swap. 90 percent choose what they got at random. This illustrates the endowment effect or status quo bias. –Difference between willingness to pay and willingness to accept in contingent valuation studies (for say species extinction) –More important is adaptation to current situation: happiness paradox, lottery winners, quadriplegics, “rat race” or “treadmill” syndrome 10

11. What are policy responses For first two, not deep philosophical issues and requires education, better information, nudges: Data incompetence: provide better data or simplify calculations (labeling, $ labeling on energy using appliances) Decision incompetence: “Nudge” to more sensible decisions with different default options (“soft parentalism”). For last two, deep philosophical and political issue about whether should respect individual preferences: “Weird” preferences: Shouldn’t we respect them? Incoherent preferences: Should governments override them? Treat people like children? 11

12. What should we think about? The gasoline paradox: People pay $0.37 for $1 of PV of gasoline savings? The organ transplant opt-in/opt-out paradox. 12

13. Defaults matter for organ transplants Eric J. Johnson and Daniel Goldstein, “Do Defaults Save Lives?” Science, Nov 2003. 13

14. First-cost v. future cost The energy efficiency puzzle: Consider the life-cycle cost of an automobile: LCC = purchase price + present value running costs = purchase price + ∑(1+r) -t FutureCost t Basic result is that the breakeven discount rate is 20+% p.y [E.g., Allcott and Wozny ≈ 60 % per year; Hausman ≈ 25 % per year] What is going on here? Incomplete information about MPG or fuel prices Risk or loss aversion High discount rates Principal-agent conflicts Computational incompetence (bounded rationality) Limited managerial time 14

15. Source: David Greene, “Uncertainty, Loss Aversion and Markets for Energy Efficiency” 15

16. The Zillion Dollar Question Are all these “anomalies” or are they central to economic behavior? 16