Government Regulation of Irrationality: Moral and Cognitive Hazards

Abstract:     
Behavioral law and economics scholars who advance paternalistic policy proposals typically employ static models of decision-making behavior, despite the dynamic effects of paternalistic policies. In this article, we consider how paternalistic policies fare under a dynamic account of decision-making that incorporates learning and motivation effects. This approach brings out two important limitations on the efficiency effects of paternalistic regulations. First, if preferences and biases are endogenous to institutional forces, paternalistic government regulations may perpetuate and even magnify a given bias and cause other adverse psychological effects. Second, for some biases, it will be more efficient to invest resources in debiasing than to change legal rights and remedies or, in some cases, to do nothing in light of the natural variation in irrational propensities. We propose dynamic models for determining ex ante and ex post when accommodation of bias will be second-best efficient. These models direct decision-makers to consider (1) the efficiency cost of the bias; (2) the extent to which accommodation worsens the bias or, alternatively, the extent to which non-accommodation improves the bias or has other benefits; and (3) the potential for education or other mechanisms to debias an individual. We argue that the concept of "cognitive hazard" - the potential for the costs of a bias to increase as individuals are insulated from the adverse effects of the bias - should be added to the concept of moral hazard as important qualifications to paternalistic proposals.

Keywords: Paternalism, Insurance, Behavioral Law and Economics, Psychology, Learning, Mistake

JEL Classifications: D6, D8, I2, K1, K2, K3

Accepted Paper Series