How government nudges may backfire

Last year, President Obama issued an executive order encouraging federal agencies to consider insight from behavioral sciences when issuing new regulations. The order pointed to cases in which many consumers make seemingly irrational choices that hurt themselves over the long-term. They overeat despite the health costs of obesity, they undersave for retirement or they fall into the debt trap by taking on high-interest debt that they cannot repay. Although the problems stemming from irrational behavior are real and often substantial, there is little evidence that regulators can effectively counter them.

{mosads}Consider the example of regulatory agencies dealing with the so-called “energy paradox,” which refers to the low rate of consumer adoption for a cost-saving technology. In other words, few consumers opt for more efficient cars even though the savings from more fuel-efficient vehicles may compensate over a few years for their higher upfront price.

In response, the Department of Transportation (DOT) and Environmental Protection Agency (EPA) established Corporate Average Fuel Economy (CAFE) standards that impose minimum fuel efficiency requirements for vehicles. The idea behind these standards is that consumers either do not understand how to incorporate future energy costs into their purchasing decisions, or they focus too much on the higher price of fuel-efficient vehicles and overlook the long-term savings. Thus, agencies argue that by forcing consumers to purchase fuel-efficient cars, the standards save consumers money. While there are some environmental benefits to these standards, consumer savings account for over 85 percent of CAFE standards’ benefits.

There are several reasons to be skeptical of government-imposed solutions. First, regulators could be wrong. When DOT and the EPA estimated the potential savings that consumers would realize from lower fuel costs, they did not expect the price of oil to plunge below $30 a barrel. The agencies used the 2011 Annual Energy Outlook projections, which predicted oil prices to stay around $125 a barrel, and certainly did not expect the prices dropping below $50. Energy analysts now predict that low oil prices will persist for some time.

Once implemented, the fuel efficiency standards are difficult, if not impossible, to reverse. This means that all consumers will gain considerably lower fuel savings than promised by the regulators. Had the regulators left it up to consumers to decide whether to invest in a more fuel-efficient vehicle, consumers would have adjusted their future savings expectations based on the current low gas prices.

Another problem is the mismatched incentives that regulators face with regard to energy efficiency. On one hand, DOT and EPA regulators attempt to help consumers save money through fuel-efficient vehicles. On the other hand, the EPA has incentive to push for greater fuel efficiency beyond the levels benefiting consumers. Since higher energy consumption leads to greater greenhouse gas emissions, improved energy efficiency would help mitigate climate change.

Mixed incentives also determine the agencies’ choice of policy tools in achieving their goals. In general, federal agencies opt for the energy efficiency policies that maximize their control. At the same time they issued fuel efficiency standards, DOT and the EPA developed a new fuel economy label. The label was designed to not only inform consumers but also counter potential biases. The label displayed the annual fuel costs and the potential fuel savings over a five-year period. It thus reminded consumers to consider fuel costs in addition to vehicle price and made it easy to incorporate these costs into consumers’ calculations.

Despite that, the EPA and DOT chose to impose a more stringent fuel efficiency standard. In their analysis, the agencies failed to even mention the fuel economy label and what impact they might have on correcting consumer biases. If the fuel economy label is as successful as the agencies’ own analysis predicts it would be, then the benefit of correcting consumer bias through mandatory fuel efficiency standards is overstated.

The agencies’ decision to pursue hard paternalistic interventions, even when less-intrusive soft paternalistic interventions are available, may be driven by the desire for greater control. While the fuel efficiency label leaves the ultimate decision to the consumer, CAFE standards allow agencies to exert a greater degree of control over the auto market.

Problems resulting from bad consumer choices can be substantial, but regulators’ ability to help is dubious. Given their incentives, regulators are more likely to use behavioral sciences to justify more stringent and intrusive regulations that serve a political agenda, not consumers’ needs.

Abdukadirov is a research fellow in the Regulatory Studies Program at the Mercatus Center at George Mason University.