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The Behavioural Turn in Law and Economics

Behavioral Law and Economics Is Not Just a Refinement of Law and Economics

L’économie du droit comportementale n’est pas simplement un perfectionnement de l’analyse économique du droit
Steven M. Sheffrin
p. 331-352


Nombre de partisans influents de l’application de l’économie comportementale au droit considèrent que l’économie du droit comportementale constitue simplement un raffinement de l’économie du droit traditionnelle. La principale différence serait que l’économie du droit comportementale emploie des descriptions plus réalistes du comportement humain comme fondements. Cet article questionne cet argument. On montre d’abord, au travers d’une série d’exemples, que les principaux promoteurs de l’économie du droit comportementale adoptent des positions qu’on peut considérer comme subversives par rapport au noyau fondamental des principes de la rationalité, sous-jacents à l’économie du droit traditionnelle. Deuxièmement, on montre que l’évaluation du bien-être diffère substantiellement du paradigme économique traditionnel utilisé par l’économie du droit.

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1. Traditional vs. Behavioral Law and Economics

1This paper contrasts scholarship in traditional law and economics with more recent scholarship in behavioral law and economics. A number of prominent advocates of applying behavioral economics to the law have made the claim that behavioral law and economics is simply a refinement of traditional law and economics. The key difference is that behavioral law and economics uses more realistic descriptions of human behavior as its foundation and thus provides a more accurate and useful understanding of the relationships between economics and the law.

2This paper takes issue with that claim. While behavioral law and economics may have important insights that legal scholars and policy makers may wish to embrace, behavioral economics is not simply a refinement of traditional law and economics. We first demonstrate through a series of examples that the strongest adherents of behavioral law and economics take positions that can be seen as subversive of the fundamentals of the core rationality principles underlying traditional law and economics. Second, and less appreciated, the assessment of welfare within behavioral economics differs sharply from the traditional economic paradigm used in law and economics.

3To understand these claims, we first need to provide some background on behavioral economics, traditional law and economics, and behavioral law and economics.

  • 1 In the United Kingdom, there is the Behavioral Insight Team while during President Obama’s administ (...)

4Behavioral law and economics rests on the foundation of behavioral economics, a subject that has made great inroads into public policy and legal studies, with serious academic research being conducted in departments of psychology, finance, accounting, marketing, and economics. Its impact has been so profound that it has even been introduced into introductory textbooks in economics (O’Sullivan, 2016, chapter 22). In the public policy realm, governments in the United Kingdom and the United States created offices devoted to applying insights from behavioral economics to public policy.1 Behavioral economics grew as a field drawing on the pioneering work in cognitive psychology by Daniel Kahneman and Amos Tversky, with additional initial contributions from economists including Richard Thaler and George Lowenstein. There are now a number of undergraduate textbooks as well in behavioral economics (Wilkinson and Klaes, 2012).

  • 2 Richard Posner’s Economic Analysis of the Law was first published in 1973.

5In the legal realm, traditional law and economics grew up rapidly from the 1970s, building on the initial insights of Ronald Coase and Guido Calabresi and then drawing in a series of talented, modern economists—including Peter Diamond, Steven Shavell, and Louis Kaplow—into its domain. Economic scholarship on crime and punishment (Becker and Landes, 1974) also flourished at this time, emphasizing the effects of incentives. From the legal scholarship perspective, Richard Posner applied basic microeconomic reasoning to a wide range of legal matters as well as elaborating on the same Coase-Calabresi connections.2 Traditional law and economics is now taught widely across the United States and has a highly regarded and influential undergraduate textbook that establishes a baseline understanding of the field and highlights microeconomic analysis of legal rules (Cooter and Ulen, 2011). The emphasis on microeconomic reasoning to understand legal rules ties all the practitioners of traditional law and economics together.

  • 3 Jolls, Sunstein and Thaler (1998) and Sunstein (2000).

6Behavioral law and economics is of a more recent vintage. The application of behavioral economics to legal issues was led initially by Cass Sunstein, who wrote articles and edited a book entitled Behavioral Law and Economics (2000).3 Sunstein’s influence grew with his important policy role in the administration of President Obama and his influential book with Richard Thaler, Nudge (2008). More recent scholarship in behavioral law and economics has been compiled in The Oxford Handbook of Behavioral Economics and Law (Zamir and Teichman, 2014). During this nearly fifteen year period—from Sunstein’s volume to the Oxford Handbook—scholars have continued to use insights in behavioral economics to refine their analysis of law. The most influential contributors to the field are represented in these two volumes.

  • 4 See Rachlinski’s (2000) discussion of hindsight bias, Jolls, Sunstein, and Thaler (1998) on informa (...)
  • 5 See the section entitled “Behavioral Economics: Legal Applications” in the Oxford Handbook of Behav (...)

7Although a full survey of behavioral law and economics is beyond the scope of this paper, the contributions have reached many issues at the intersection of law and economics. Examples of this approach include using the idea of “hindsight bias” to refine standards in tort law, using behavioral concepts to suggest novel regulatory strategies for the provision of information in markets, uncovering the effects of framing on punitive damage awards and suggesting methods to remedy any biases, and understanding the consequences of the failure of economic agents to take advantage of opportunities to bargain for mutual gain.4 In the Oxford Handbook, scholars also explored the role of alternative behavioral approaches towards topics typically dealt with in traditional law and economics including torts, contracts, property law, corporate law, tax law, litigation, judicial decision-making, as well as criminal law and environmental law.5

  • 6 Posner (2003) makes a similar point with respect to traditional law and economics and contract law.

8At a high level of abstraction, both traditional and behavioral law and economics draw from the tradition of applying social science research to the study of law, with law and economics emphasizing economic analysis and behavioral law and economics supplementing economics with psychology. This stands in contrast to an exploration of the foundations of contracts, torts, or property based on purely doctrinal analysis, derivations from philosophical principles, or historical analysis. Both branches of scholarship draw on modern social science for their insights.6

9This paper focuses on the differences between traditional and behavioral law and economics. The conventional view of this relationship—typically offered by proponents of behavioral law and economics—is that it is simply a refinement of traditional law and economics by incorporating more realistic behavioral assumptions. This is my interpretation of the motivation of Jolls, Sunstein, and Thaler (1998, 13) who strongly advocate for incorporating behavioral principles into legal analysis to increase our understanding of law: “Our goal in this chapter is to advance an approach to the economic analysis of law that is informed by a more accurate conception of choice, on that reflects a better understanding of human behavior and its wellspring.” In this view, behavioral law and economics refines the analysis in traditional law and economics by simply incorporating more realistic economic modelling assumptions into the law and economics paradigm. Richard Thaler (2006, 1597) expressed precisely this sentiment for behavioral economics: “If economics does develop along these lines the term ‘behavioral economics’ will eventually disappear from our lexicon. All economics will be as behavioral as the topic requires.”

  • 7 My view is consistent with the sentiment expressed in the title of Korobkin’s (2011) paper, “What C (...)
  • 8 An alternative criticism of traditional law and economics is that it fails to consider law as a nor (...)

10I take a contrary view in this paper and argue that embracing behavioral law and economics effectively leads to a subversion of traditional law and economics and a rejection of its basic approach.7 In this view, adopting well-articulated behavioral principles so undercuts the traditional analysis of traditional law and economics that little of it can be said to survive. This subversion may be either conscious or unconscious on the part of behavioral law and economics practitioners, but the effects are the same either way. Little of traditional law and economics survives under this view.8

  • 9 For purposes of this paper, I use the term “ardent behaviorists” to refer scholars including Cass S (...)

11This paper makes two arguments in favor of the subversive view. First, I argue that a full acceptance of common behavioral principles when applied to the law, such as context-dependent preferences and the endowment effect can be seen as subversive, as those principles undercut the foundational assumptions of traditional law and economic analysis. Through an analysis of archetypical examples, I demonstrate that if the behavioral program is implemented in the spirit of its most ardent behaviorists, little is left of traditional law and economics.9

12Second, the paper explores the differences in welfare analysis between traditional and behavioral law and economics. Drawing on recent scholarship, I emphasize the fragile nature of the conclusions about welfare that can be drawn from behavioral economics. Unlike traditional law and economics, behavioral models often feature unstable preference orderings which creates difficulties for systematic welfare analysis.

13To make these arguments, I present canonical treatments of traditional and behavioral law and economics. I argue that the alternative perspectives on rationality and welfare in behavioral law and economics often will undercut the typically strong conclusions drawn from traditional law and economics. I should emphasize that the focus of this paper is on the logical consequences of accepting a set of behavioral principles as true facts about the world, but I take no definitive position in this paper on the veracity of those principles.

  • 10 Although he uses the term “heuristics and biases” I believe he is referring to general insights fro (...)
  • 11 Mitchell (2014) does not discuss normative or welfare issues in his paper.

14The argument in this paper differs from Gregory Mitchell’s (2014) recent interesting critique of behavioral law and economics. Mitchell contends that the field relies too heavily on the “heuristics and biases” work of the cognitive psychologists and thus limits itself to one aspect of psychology.10 Moreover, he believes a better approach to behavioral law and economics would be to conduct sophisticated empirical analyses of concrete topics in the legal realm, incorporating as wide a variety of possible psychological phenomenon as necessary to explain the empirical phenomenon. The arguments in this paper are different. We do not take a position on whether the “heuristics and biases” psychological approach is ultimately true, but merely assert that its wholehearted adoption sharply undercuts traditional law and economics. Another important contribution of the paper is to argue that welfare analysis becomes much more problematic under traditional behavioral assumptions.11

2. What is Traditional Law and Economics?

15To illustrate the operation of traditional law and economics, I will start with an example from Louis Kaplow and Steven Shavell in Fairness and Welfar (2002). Their book analyses simple models of torts, contracts, legal procedures and law enforcement through an economic lens. While their book attracted notoriety because it claimed that principles of “fairness” were not consistent with welfare, our focus here is simply on the logic of their economic models, which we highlight because they make the role of economic analysis so clear.

  • 12 In this example, we just consider two legal rules: specific performance or expectations damages.
  • 13 Posner (2003) emphasizes that traditional law and economics does not assume the full set of conting (...)

16Let’s take the simplest contract case to illustrate the operation of traditional law and economics (Kaplow and Shavell, 2002, 172-186).12 Suppose a contractor is making a table valued by a customer at $200. Production costs could be either $100 with a 0.9 probability or $500 with a 0.1 probability. The parties are risk-neutral and wish to split the gain from contact. In the case in which a complete contract (a contract that specifies all possible contingencies) can be written on the realized costs, there are two possibilities, a contract that always requires production and one that only requires production when the costs are below $200. In this case, it is clear that the optimal contract will only require production when the costs are below $200. Either specific performance in the ideal contingent contract (producing only when the cost is $100) or paying expectations damages (paying the buyer $200 instead of producing the table when the cost of production is $500) would be consistent with the contract. However, if contracts are incomplete and cannot be written contingent on the outcome, then specific performance does not yield the right outcome—it would lead to producing a table valued at $200, at a cost of $500. Expectations damages would produce the efficient outcome in this case.13

17Now the analysis of the legal rule depends on the rationality and sophistication of two parties. The buyer of the table should not want to have a system in place which requires the producer to manufacture the table when the costs exceed $200. The reason is that the deal that would be struck between the parties would be better off ex ante for the buyer if production did not occur in this case. So the buyer should not want a system of specific performance in the incomplete contract case, even though it would guarantee that he would get the table regardless of the outcome. The example also requires that the buyer’s valuation cannot be highly fragile or contingent. For example, we must assume that the value of $200 that the buyer places on the table is not whimsical and does not suddenly rise to $300 if he learns that the seller decides not to produce the table. This example also assumes basic rationality on the part of the producer. When costs rise above $200, the producer breaches the contract and pays $200—the producer cannot feel guilty about disappointing the customer by not fulfilling an obligation.

18Moving away from the contract example, another classic set of law and economics cases involve externalities. Consider the classic Coase example where a rancher and a farmer face a situation where their actions adversely affect each other. A rancher’s cattle can cause damage to crops and a farmer’s fencing will impede profitable cattle production. With costless bargaining, the solution is to reach the outcome that jointly maximizes benefits. For example, if the benefits to the rancher from additional grazing exceed the damage to the farmer’s crops and the law requires the rancher to pay the farmer for damages, then grazing will occur with the rancher compensating the farmer. If the law does not require compensation to the farmer, then the rancher will simply graze on the farmland and farmer will pay the rancher to cut back only when the damages to the crops exceed the additional benefits from grazing. The legal rule will affect the distribution of gains but not the outcome in terms of the scope of grazing—this is Coase’s famous result in the costless bargaining environment.

19This example presumes that the legal rule does not frame the parties’ interactions by introducing new preferences or valuations. The fact that under one legal rule the farmer is entitled to compensation whereas under an alternative he is not, should not affect the rational calculations that the farmer and the rancher make in reaching their bargain. Again, there can be no contingent psychological changes in valuation based on the legal rule.

  • 14 For a clear discussion of this point, see Seidman (2009, 28-34).

20Now let’s move to a more complex market situation where there is an externality—for example, pollution. It is a well-known result in economics that a regime of taxes on polluters can be replicated by a market for tradeable emission permits.14 In the case of pollution taxes, the producer determines the optimal level of output by weighing on the margin the extra profits from production against the extra cost incurred by the pollution tax. In a marketable trading system, producers are endowed with a fixed number of credits that allow them to emit pollution. Producers will buy and sell credits to pollute, again basing their decisions on the relative costs and benefits of buying a credit to pollute or selling a credit and reducing pollution. The supply of credits can be adjusted to ensure the equivalent result that would occur for any given pollution tax. In both cases, there are the same marginal calculations that rational actors are required to make.

21We must, however, make behavioral assumptions in several layers of this process to ensure this equivalence. First, under both regimes, the parties are assumed to make decisions based on either the actual costs they incur by paying a tax or purchasing a permit or the opportunity costs dictated by the market from not selling a permit. Opportunity costs must be treated symmetrically to out of pocket costs. As we discuss below, behavioral economics denies this equivalence. Second, the actual market for tradeable permits is assumed to operate in an efficient manner in which prices accurately convey the relative cost information of the buyers and sellers and is fully reflected in the equilibrium price for the tradeable permit. Individuals respond to the market in a fundamentally similar way they would respond to a direct tax.

3. The Innovations from Behavioral Law and Economics

22There are many different strands in behavioral economics that are now in common usage. In order to focus on the contrast between traditional and behavioral law and economics, I will highlight just two of several themes in behavioral economics. These two themes are context-dependent preferences and the endowment effect, with its related phenomena.

  • 15 See the example of buying a soda on the beach in Thaler (1999, 189)

23Context-dependent preferences are based on the idea that the “frame” or the way options are presented will influence choices. There are many different variations on this theme and some have been applied in legal contexts. For example, experimental evidence suggests that how jury instructions are presented in terms of alternative options could have an impact on verdicts (Kelman et. al., 2002). Framing of punitive damages also matters (McCaffery et. al., 2000). More generally, preferences or rankings can depend on incidental (and not normally relevant) features of the legal or economic environment.15

24The endowment effect is based on the idea that individuals place extra value on an object once it is in their possession. In other words, they may value an object at $x if someone else has it, but once they have it in their possession, the object becomes worth more, say $y. The gaps between $y and $x can be extremely large, as extensive empirical work has demonstrated (Ariely, 2008, chapter 8). Once someone has possession of the object, they will require $y to part with it whereas they would only require $x to purchase it.

  • 16 Loss aversion is part of Prospect Theory as developed by Tversky and Kahneman (1981). For a useful (...)

25Closely related to the endowment effect is the phenomenon of loss aversion, which is the idea that people strongly prefer avoiding losses than acquiring gains. Surrendering one’s endowment for money can be viewed as a loss whereas acquiring the same good for money can be viewed as a gain.16

26Loss aversion is probably one of the most robust results in behavioral economics; indeed, scholars have suggested in many different contexts—including legal contexts—to design incentives around loss aversion (Jolls, 2002, 44). Fryer et al. (2012), for example, have suggested that incentive systems for teachers involve removing prepaid bonuses for teachers rather than rewarding them with varying bonuses after student performance is determined. They provide evidence from a field experiment that the loss-aversion frame leads to improved student performance.

  • 17 The discussion here presumes that both out of pocket and opportunity costs are both measurable and (...)

27In the same conceptual family as the endowment effect and loss aversion is the phenomenon that out of pocket costs seem to weigh more in decisions than opportunity costs. Out of pocket costs are perceived as real losses, whereas opportunity costs are mere foregone gains, and are not valued as much as equivalent losses. This reflects loss aversion because out of pocket costs are viewed as real costs, while opportunity costs are simply potential gains.17

28Let’s apply these two simple concepts to the methods and approaches underlying traditional law and economics. First, consider context-dependence preferences in the case of contract negotiation. As we noted in our discussion of a contract for producing a table valued by a buyer at $200, the conclusions we reached concerning why it is optimal to breach a contract in the high cost case required that the value placed by the buyer of the table did not depend on the realized cost of production. With that assumption, we were able to conclude in the incomplete contract case that only the expectations damage principle achieved efficiency.

29But suppose that preferences are context-dependent so a buyer might simply feel that a table is worth more to him or her personally if the costs of production are high. Don’t we all change our valuations if we think something is more costly to produce? Now, if both the buyer and seller understood these preferences ex ante, they would reach a very different outcome than predicted by traditional law and economics. The buyer would insist on specific performance which would reduce the surplus to be shared by both parties, relative to the efficient contract as dictated by the theory. On the other hand, if the buyer did not realize that his or her preferences would change, they would be dissatisfied with a payment of $200 under the expectations damage regime. How the individual would respond in this case is not clear, but one could envision court proceedings or subsequent litigation.

  • 18 Korobkin (2000) and Eisenstein (2014) address similar issues.

30Legal rules might themselves provide a vehicle for context-dependent preferences. Suppose, for example, that a legal rule entitles a property owner to be paid compensation for any intrusion on her property. Because of the endowment effect, this may create the belief in the owner that she has a special relationship to the property, above and beyond the normal prerequisites of ownership. In that case, an intrusion onto the property may be valued more than it would have been without the extra valuation created by the legal rule. Thus, the owner may insist on additional compensation beyond the typical amount that would occur in a typical bargain.18

31Consider a few more examples that take into account loss aversion and the lack of parity between out of pocket costs and opportunity costs. First, a farmer in the Coase setting should consider the opportunity cost of not letting a rancher pay for damaging his crops. If that opportunity cost is not valued correctly, the two parties will reach an outcome that is not economically efficient. Second, consider the market for tradeable pollution permits. It is essential for an effectively functioning market that the holders of permits who can reduce pollution at a cost lower than the current market price for the permit be willing to sell their permits into the market. But again, the funds gained from selling a permit are opportunity costs. If an endowment effect mentality is operative, then a seller may not wish to depart with a tradeable permit, even if this would be the economically efficient outcome. In this case, the market itself would not work efficiently and there no longer would be a presumed equivalence between pollution taxes and a tradeable permit regime. This would be inconsistent with traditional law and economics.

32The environmental arena provides a number of other examples where the endowment effect challenges the predictions from traditional law and economics. Economists have long recognized that, as an empirical phenomenon, the willingness of individuals to pay for pollution abatement is much less than the willingness of individuals to accept additional pollution. For example, consider a lake that is 5 percent polluted and survey individuals to determine how much they would pay to restore the lake to its pristine character with zero pollution. That amount would typically be much less than they claim would be required to pay them to reduce the quality of a lake from its pristine character to one in which there is 5 percent pollution. While this finding may seem quite intuitive—after all, who wants to be responsible for polluting a lake?—it runs counter to the basic tradeoffs involved in comparing the marginal benefits and costs of pollution.

33According to basic economic principles, individuals may value pollution abatement, but should have stable preferences in trading off dollars against pollution. These should use these preferences to calculate the optimal level of pollution—whether it is 1 percent, 5 percent, or 10 percent economic theory is silent. But this calculation should not depend on whether the lake is originally polluted or not. This is just another example of the endowment effect in action—possessing a pristine lake will change one’s preferences.

34As this example intimates, preferences generated through the endowment effect may lead to inconsistent rankings of outcomes (Knetch, 1989). With inconsistent rankings, not only does it make it extremely difficult to ascertain the optimal level of pollution—is it 1, 5 or 10 percent?—but it also makes it especially difficult to analyze the consequences of alternative legal rules. In order to make definitive assessments, traditional law and economics assumes underlying economic rationality in evaluating the consequences of alternative legal rules. Without the underlying rationality, it no longer becomes possible to draw out the legal consequences of alternative legal regimes.

35These examples illustrate how both context-dependence preferences and the endowment effect undercut the most basic analyses of traditional law and economics. Of course, whether these behavioral phenomena are pervasive is contested intellectual terrain.

  • 19 See Sunstein (2014) for a detailed discussion of nudges.
  • 20 Sunstein and Thaler in Nudge (2008) discuss defaults extensively.
  • 21 This logic is pursued in Bernheim et. al. (2015).

36Although a full survey of the empirical import of behavioral economics is beyond the scope of this paper, we can offer a few generalizations. First, with respect to context-dependent preferences, there is very strong evidence that default choice presented to individual matter considerably in a variety of contexts, including contributions to 401(k)s, the purchase of disability insurance, and other important home and workplace decisions.19 If an individual has to opt-out of disability insurance, she is more likely to choose the insurance than if she has to opt-in for the insurance. One way to understand default setting is to think of them as framing choices. Then, the strong evidence for the effects of default choices can be construed as evidence in favor of context-dependent preferences.20 On the other hand, choosing an alternative other than a default requires effort. If these effort costs are significant, then we cannot conclude a priori from the evidence on defaults that preferences are context-dependent.21 However, in a variety of cases, choosing a non-default alternative is not all that costly in an objective sense—particularly relative to the potential gains from making the correct choice. Unless deviating from a default situation is very costly, then the fact that defaults so radically change behavior is evidence for strong context-dependent preferences.

37Second, there is less agreement on how ubiquitous the endowment effect is beyond simple laboratory settings in which the endowment effect is well established. John List (2003), for example, has shown that sophisticated professional baseball card traders grow less susceptible to these biases over time. The presumption would be that in sophisticated commercial markets one would not expect to see the endowment effect operating. On the other hand, Fryer and his co-authors (2012) (which include List) also believe that loss aversion can create powerful incentives for behavior.

  • 22 These settings would include individual choices from menus of opportunities. For a list of some var (...)

38In many settings highlighted by behavioral theorists, markets themselves do not really matter.22 If a worker defaults into a poor decision about the level and composition of his retirement savings or disability insurance, then no market will “save” the worker from his mistake. In these cases, the institutional setting is unforgiving and no informed agents can come to the rescue.

39Another prominent example where markets cannot guide individual choices is the phenomenon of internalities, or inefficient decisions made by individuals because of either defective decision making or some type of inefficient preferences. The classic example here is time-inconsistent preferences in which an individual at time t will plan to take action x at time t+1 but, in fact, they end up choosing action y at time t+1 instead. You may smoke or overeat now, but believe you will stop smoking and go on a diet in the future. When the future rolls around, however, you continue smoking and overeating. Markets will also not save you in this case—the fault lies directly with the individual (Gruber and Koszegi, 2008).

  • 23 In another example, behavioral game theory questions whether individuals act as if they follow back (...)

40To summarize the argument to this point, two of the most important contributions from behavioral economics—context-dependent preferences and the endowment effect—imply results that can run directly contrary to the assumptions underlying traditional law and economics. The close connection between traditional law and economics and conventional economic rationality is the issue, as behavioral economics challenges the very foundation of the rational calculus used in the analysis of legal rules. We should emphasize here that the principles of rationality challenged by behavioral law and economics in this context are very basic—for example, the equivalence of out-of-pocket and opportunity costs.23

41Perhaps this argument against traditional law and economics is overdrawn. Here is one defense. It could be the case that behavioral principles become so well established and empirically grounded that they can be used to replace or complement traditional rationally assumptions. As the title of Dan Ariely’s best seller implies, perhaps humans are Predictably Irrational (2008). By this phrase we imply that non-rational behavior is not simply any wild alternative to classic rational principles—instead there is a well-defined set of biases that individuals possess and through careful study we can just use these in our modelling of behavior and legal rules. Loss aversion may be a good example of one. Moreover, we do not have to establish perfection in this quest—after all, practitioners of traditional law and economics have long recognized deviations from rationality in their analysis, they made no pretense that their models were universally accurate. However, they simply argue that economic rationality provides the most reliable approach to the analysis of the law. In a similar vein, one could simply argue that behavioral law and economics does not achieve perfection but simply deepens the analysis.

42Kaplow and Shavell recognized this possibility in their treatise Fairness versus Welfare (2002, 461-463), in a section entitled, “The Difficulty of Predicting the Behavior of Individuals Who Are Not Always Rational Maximizers of Their Own Well Being”. Their underlying position is quite balanced:

We believe that the standard assumption of rational maximization is apt for many legal applications—notably the study of the behavior of private enterprise—and has proven to be useful in a wide range of other settings. Nevertheless, when behavioral economics, cognitive psychology, evolutionary biology, sociology, or anthropology yields valid insights, they should be incorporated in legal policy analysis. (Kaplow and Shavell, 2002, 463, citations omitted.)

43They emphasize that although these alternative approaches may yield better predictions of behavior, improvements in positive economics, we still should rely on traditional principles of normative assessment based on maximization of stable individual preferences.

44Kaplow and Shavell present two examples where behavioral insights may be important in developing better positive economic models of behavior. Cognitive psychology may establish that physicians may overreact to highly publicized jury verdicts on medical malpractice. This finding could change the relative balance of alternative legal rules in determining the best approach to induce the proper level of precautionary behavior on the part of doctors. In another example, suppose that widespread non-compliance in the tax system spills over to individuals and causes them also to become more non-compliant. In this case, the optimal penalties for non-compliance and the level of resources devoted to detection of non-compliance by the tax authorities would change (Kaplow and Shavell, 2002, 463). Despite the nod that two prominent practitioners of traditional law and economics give to behavioral approaches, there are two potential problems with this strategy of accommodation and assimilation of behavioral factors into law and economics. The first is the lack of quantitative precision of behavioral economics as it stands today. The second, which is perhaps even more fundamental and we defer to next section, is the difficulties that behavioral economics poses for the assessment of welfare.

  • 24 See also the extended discussion of these issues in Diamond and Hausman (1994).

45In its current state of knowledge, behavioral economics can be suggestive of strategies that lead to changes in behavior, but cannot provide narrow ranges for the scope of its effects. For example, the differences between measures of willingness to pay versus willingness to accept in environmental studies range widely and are notoriously fragile. Part of the reason is that the method used to determine differences between willingness to pay and willingness to accept typically relies on hypothetical scenarios posed to individuals. This method of contingent valuation has attracted a good deal of scientific skepticism. In the title of a well-known article, MIT economist Jerry Hausman (2012, 43) suggested the method of contingent valuation ranged from “dubious to hopeless.”24

46While there are experimental studies of the endowment effect, most are laboratory studies with the recognized problems of external validity in generalizing to phenomenon outside the narrow confines of the laboratory. Dan Ariely conducted a fascinating field experiment with Duke basketball tickets by comparing the willingness to pay and accept for losers and winners of a lottery among passionate basketball fans. His finding that winners of the lottery would only sell their tickets for $2400 whereas losers would only buy tickets for $170 was striking but well out of the range of typical estimates of the endowment effect. Typical estimates of willingness to accept to willingness to pay are usually less than two to one, not over the twelve to one that Ariely found (Kahneman et al., 1990). Thus, while most studies do find evidence for an endowment effect, its quantitative measure is uncertain. In that case, how can behavioral law and economics analyze the alternative consequence of legal rules, except by making them very context-dependent?

  • 25 In an email, Daniel Kahneman warned of a “train wreck looming” in terms of reproducibility of resul (...)

47The same type of problem arises in analyzing the quantitative responses to nudges. One of the primary motivations for creating the Behavioral Insight Team in the United Kingdom and the Social and Behavioral Science Team in the United States was to provide quantitative estimates of the efficacy and effects of nudges from the public sector. Both groups used field studies to test different behavioral strategies. The groups are equipped with basic hypotheses supplied by research in behavioral economics, but often little quantitative guidance. For example, investigators may wish to find out how to reduce the accounts receivable of a tax authority—that is, how can we increase the amount and speed of payment from taxpayers who have been contacted by the authorities and asked to remit more taxes (Hallsworth et al., 2014)? Should we use fear and emphasize penalties or should we emphasize virtues of being a good citizen? What about highlighting the speed at which other taxpayers settle their bills? The results of such a study could be extremely valuable to the tax authority and more than justify the costs of this type of field research. Indeed, the authors of a recent study found that including social norms and public goods messages in letter from authorities did speed up payments. While the research may be clearly worthwhile, one natural question is how well does it generalize? Do appeals to patriotism always trump fear—or, as some studies have suggested, do references to comparison groups matter the most (Thaler and Sunstein, 2008, chapter 3)? It is safe to say that we are a long way away from establishing any of these viewpoints as universally valid and even further away from achieving reliable quantitative estimates. The fragility of quantitative measures in behavioral economics mirrors the tentative and often uncertain conclusions in social psychology that have been recently been the subject of some attention.25

48While the same critique could be leveled at traditional economics, there is typically more theoretical guidance from basic price theory as to where to measure and look for the effects of policies. Perhaps someday behavioral economics could reach that point, but the open ended experimentation of the governmental entities and their frank admissions that their findings are context-dependent, suggest otherwise.

4. The Welfare Conundrum in Behavioral Economics

  • 26 This is a contested issue. See McQuillin and Sugden (2012). As discussed below, Bernheim and Rangel (...)

49Recall from our discussion of Kaplow and Shavell that they were in principle willing to introduce behavioral principles into their positive analysis of legal rules, but insisted on using welfare maximization as the basis of normative claims.26 By welfare maximization in this context, they simply meant that social states should be evaluated on the basis of well-defined preferences of individuals, characterized by stable preference orderings over both market and non-market goods. If individuals differ in their preferences then a further tool—a Social Welfare Function—is necessary to evaluate social states. If individuals have identical preferences, then any individual can stand in for the rest.

  • 27 The difficulties highlighted in this section about preference reversals also apply to approaches ba (...)

50Kaplow and Shavell distinguish welfare maximization based on stable preferences from wealth maximization as popularized by Richard Posner in his early work in law and economics. In wealth maximization, only dollar amounts matter—whereas, in welfare maximization market and non-market goods including leisure, the environment, and anything else that affects individual well-being matter.27 Kaplow and Shavell use their welfare maximization approach to analyze legal rules and argue against non-welfarist criteria, such as various claims of “fairness,” as an alternative basis for evaluating legal rules on the grounds that other rules (almost by definition) must lead to outcomes that do not maximize welfare. We can set aside the details of that debate, but simply note that welfare maximization does require stable preferences to be a meaningful and operational theory.

51All of this is based on some deep notion of revealed preferences. From what individuals choose, we can infer what individuals prefer. That is the essence of the revalued preference approach—actual choices reflect true and stable preferences.

52Behavioral economics effectively denies that preferences are necessarily stable. Context-dependent preferences are rooted in the idea that other factors in the environment—such as arbitrary frames—can shift preferences. One example of an arbitrary frame would be to cast outcomes as losses from some status quo point as opposed to gains as viewed from another vantage point. This is the genesis of the endowment effect.

  • 28 Korobkin (2011) suggested that abandoning revealed preferences focuses increased attention on the v (...)

53Proponents of behavioral law and economics have recognized that if actual choices do not represent true underlying preferences, then the traditional normative foundation for analyzing legal rules becomes problematic. Russell Korobkin (2011), a well-known contributor to the behavioral law and economics literature, made this point explicitly in a provocative paper in which he raised, but not answered, some philosophical and methodological issues that come with a rejection of revealed preference.28

54At this abstract level, it is clear that behavioral factors pose problems for welfare orderings. Suppose an individual can rank a set of outcomes i=1 to N, but the ranking depends upon the specific frame. If the frame is F, there is one ranking, whereas if the frame is F’ there is another ranking. Under frame F, outcome 1 is preferred to 2, whereas under frame F’, outcome 2 is preferred to outcome 1. What can we say about the rankings in this case?

55Douglas Bernheim and Antonio Rangel (2009) have developed an extensive theoretical treatment of these key issues. They first suggest that one approach would be to simply rule out a priori that some frames are valid. For example, if frame F’ had not even a remote relationship to the relevant choice set—say it was whether the outcome of a roulette wheel in Macao was red or black—this would be ruled out as a valid frame. Note that even in this case, the social judgment of states we would make would differ from the individual judgment made by the person with frame F’ but in this case we are resigned to that because we are willing to rule out F’ as a relevant frame.

56The more common case, however, is when we are not able to rule out a particular frame. Bernheim and Rangel then suggest that we have to rely only on orderings that dominate others under all relevant frames. In our previous example, we could not say whether state 1 was more desirable than state 2 because their ordering depended upon the frame. But suppose under either frame, both state 1 and 2 were preferred to state 3; then we could say that 3 was inferior to either 1 or 2. Notice that this approach may still allow for some orderings, but there will always be a set of outcomes that cannot be ranked because their relative preference depends on the specific frame.

  • 29 A simple presentation of this idea is in Gruber and Koszegi (2008).

57One commonly encountered context-dependent phenomenon is time-inconsistent preferences. Let’s focus on the case of smoking. Smoking brings immediate enjoyment, but there are health consequences later. Depending upon people’s preferences, they may want to smoke now, but vow to quit later. When the later period arises, they continue smoking. This behavior can be easily modelled with what are known as β, δ preferences.29 In this framework, the parameter δ is the normal rate of time preference and by itself would not lead to time-inconsistent behavior. However, the parameter β introduces a “present-bias” that induces time-inconsistent preferences. With this simple framework, economists can estimate both parameters, and they consistently find that β is less than one, evidence of present-bias.

58Jonathan Gruber and Botond Koszegi (2008) used this model to analyze the welfare effects of taxes on cigarettes. In their welfare analysis, they assumed that β<1 represented a deficiency of decision making capacity, and analyzed the effects of taxes on welfare evaluated when β was set equal to 1.

59Using this assumption, they concluded that high cigarette taxes could actually make low-income smokers better off, contrary to the normal conclusions about the welfare effects of cigarette taxes. The reason for this result was that smokers were making their decisions inefficiently (they were subject to an internality and should not have been smoking or smoking as much) and higher taxes were particularly effective in dissuading low income individuals to quit. Since quitting improved their welfare, even though they did not have the willpower to quit without the taxes, it made them better off.

  • 30 Another classic and accessible reference is Schelling (1984). See also Benabou and Tirole (2002).

60But of course this result depends upon accepting the premise that the β<1 preference or present-biasedness is somehow defective and should be ignored. But what basis do we have for this judgment? Following Richard Thaler and Hersh Shefrin (1981) and others, we can view the individual as having essentially two selves.30 There is the foresighted planning self, looking ahead at future smoking behavior and its health consequences; and then there is the immediate self, deciding in the moment whether to smoke or not. What self should we privilege? Do we want to favor the foresighted self on the grounds that he or she is truly rational and anticipates all the consequences of actions? Or do we think that this perspective is too detached and impersonal and only the self in the moment, the existential self, really has a firm grasp of one’s personal situation?

61Now you may side with the foresighted self in the smoking case. But if you side with that self in the smoking case, who would you side with in the case of a woman in labor and suffering excruciating pain who asks for pain relief which, prior to labor, she told her doctor in absolute terms not to administer to her (Schelling, 1984)?

62There is not a simple and general answer to this conundrum. For smoking, our intuitions today suggest that we should favor the foresighted self, particularly because so many people wish to cease smoking. However, attitudes towards smoking have changed radically in a generation and in 1950 the vast majority of individuals would have sided with the smoker. And in the case of pain relief under labor, almost everyone would side the woman in labor, even if they know she would regret her decision later.

63To reach a policy conclusion on the optimal level of cigarette taxes, behavioral law and economics must take a position on this issue. But the decision about what aspects of preferences to respect does not have a strong scientific basis. In some cases, we may want to take a paternalistic stand and in others we may not. We may want individuals to save more for retirement and use a series of clever nudges to push them in that direction. But in other cases, we may not have the requisite social agreement. Our degree of moral consensus may be high for some social phenomena but not for others. But even when we do have a moral consensus, it is just that—a moral and not scientific consensus, and one not rooted in any systematic treatment of individual welfare that we can simply write down or use to distinguish one case for another. The seeming precision of welfare economics is replaced by the thoughtful but equivocating field of applied ethics.

5. The Limits to Behavioral Law and Economics

  • 31 The endowment effect and context dependent preferences in general are examples of preference orderi (...)

64There is now a considerable body of research that has demonstrated that the insights from behavioral economics have real implications for behavior for households and in markets, and not just in laboratory settings. Two of the core insights—context-dependent preferences and the endowment effect—provide penetrating critiques of the basic rationality assumptions that undercut the traditional analysis in law and economics.31 That is not to say that in many commercial contexts, we would be best suited to continue to rely on traditional law and economics for our guiding principles. Large, impersonal and organized markets may often be best modeled under traditional rationality assumptions and there may be less of a need to deviate from the insights and methods of law and economics in these cases. But when we move from purely commercial setting to the more personal realm, including but not limited to individual or household decision making, crime and punishment, and the host of personal interactions individual have with the market, we may find that that the insights from behavioral economics prevail.

65This would be a perfectly satisfactory state of affairs if behavioral law and economics provided us with robust alternative paradigms. But for the reasons we discussed, it does not achieve this level of generality. There is “predictable irrationality” but it is not as predictive or reliable in terms of predicting behavior as we require. Instead, we must rely on field studies to test our theories of nudges and examine their efficacy and power in individual settings. But it is unlikely that a nudge in one area works precisely the same as a nudge in another area.

  • 32 For a discussion of the efficacy of nudges and the compatibility of the soft paternalism in nudges (...)

66Even if we find effective nudges, it is not clear what we do with them. The welfare analysis in behavioral law and economics is still a highly contested domain.32 What frames do we accept as valid and which ones do we rule out as an inappropriate? Which self or selves do we recognize as the appropriate decision maker and which ones do we view as inappropriate? Again, it is difficult to lay to general rules that handle all cases. Instead, we must explore and discuss each one on a case by case basis to determine if we possess the social consensus for the required moral judgments. This is a larger task than just applying a theory and drawing conclusions.

67Behavioral law and economics provides a valuable but piecemeal set of tools and insights to assist us in social policy. It may help us to think through social policies towards obesity, smoking, alcoholism, compliance with the law, and individual savings behavior. Many areas of law already reflect different standards for transactions directly affecting individual and those that are primarily business-to-business. For example, truth-in-lending laws apply to individual borrowers. The contributors to Sunstein’s edited volume (2000) and the Oxford Handbook (Zamir and Teichman, 2014) also explored, with a behavioral perspective, traditional legal topics such as punitive damages, contract formation, jury awards for pain and suffering, and the regulation of risk. These are important areas of law and policy and intellectual and policy contributions in this area will be welcome. But the contributions are not likely to be all the same—they will be dependent on context, social attitudes and norms, and other general cultural phenomenon. As long as we recognize these limitations, behavioral law and economics can inform our legal and social deliberations and provide new insights for social policy.

Thanks are due to the editors of this special issue and to the anonymous referees.

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1 In the United Kingdom, there is the Behavioral Insight Team while during President Obama’s administration the Social and Behavioral Science Team was created.

2 Richard Posner’s Economic Analysis of the Law was first published in 1973.

3 Jolls, Sunstein and Thaler (1998) and Sunstein (2000).

4 See Rachlinski’s (2000) discussion of hindsight bias, Jolls, Sunstein, and Thaler (1998) on information provision issues, McCaffery, Kahneman, and Spitzer (2000) on framing and punitive damages, and Korobkin (2000) on failures of Coasian bargaining.

5 See the section entitled “Behavioral Economics: Legal Applications” in the Oxford Handbook of Behavioral Law and Economics (2014). Papers using behavioral psychology to provide alternative perspectives include Halbersberg and Guttel (2014) on psychology and tort law, Eisenberg (2014) on psychology and contract law, and Sunstein (2014) on regulation.

6 Posner (2003) makes a similar point with respect to traditional law and economics and contract law.

7 My view is consistent with the sentiment expressed in the title of Korobkin’s (2011) paper, “What Comes After Victory for Behavioral Law and Economics?” and his comment that “the battle to separate the economic analysis of legal rules and institutions from the straightjacket of strict rational choice assumptions has been won.” (Korobkin, 2011, 1655)

8 An alternative criticism of traditional law and economics is that it fails to consider law as a normative order as in the work of Hans Kelsen. For a discussion of this point in contrasting Posner versus Kelsen, see Malecka (2016).

9 For purposes of this paper, I use the term “ardent behaviorists” to refer scholars including Cass Sunstein and Richard Thaler.

10 Although he uses the term “heuristics and biases” I believe he is referring to general insights from cognitive psychology which would include context-dependent preferences and the endowment effect.

11 Mitchell (2014) does not discuss normative or welfare issues in his paper.

12 In this example, we just consider two legal rules: specific performance or expectations damages.

13 Posner (2003) emphasizes that traditional law and economics does not assume the full set of contingent contracts normally analyzed in the economic contracting literature. As a result, the contracts that are considered in traditional law and economics are not necessarily drawn from the set of optimal contracts.

14 For a clear discussion of this point, see Seidman (2009, 28-34).

15 See the example of buying a soda on the beach in Thaler (1999, 189)

16 Loss aversion is part of Prospect Theory as developed by Tversky and Kahneman (1981). For a useful discussion, see Wilkinson and Klaes (2012, 167-171).

17 The discussion here presumes that both out of pocket and opportunity costs are both measurable and comparable. There may be situations in which opportunity costs of an action are purely subjective. In that case, the analysis would not apply.

18 Korobkin (2000) and Eisenstein (2014) address similar issues.

19 See Sunstein (2014) for a detailed discussion of nudges.

20 Sunstein and Thaler in Nudge (2008) discuss defaults extensively.

21 This logic is pursued in Bernheim et. al. (2015).

22 These settings would include individual choices from menus of opportunities. For a list of some varied examples, see chapter 16 in Thaler and Sunstein (2008).

23 In another example, behavioral game theory questions whether individuals act as if they follow backward deduction and rule out non-credible equilibria.

24 See also the extended discussion of these issues in Diamond and Hausman (1994).

25 In an email, Daniel Kahneman warned of a “train wreck looming” in terms of reproducibility of results on priming studies in social psychology. See Bartlett (2012).

26 This is a contested issue. See McQuillin and Sugden (2012). As discussed below, Bernheim and Rangel (2009) have made progress in reconciling behavioral economics and normative welfare economics.

27 The difficulties highlighted in this section about preference reversals also apply to approaches based on wealth maximization.

28 Korobkin (2011) suggested that abandoning revealed preferences focuses increased attention on the value of autonomy, the search for heuristics to understand preferences, and the necessity to understand differences between individuals in acting in ways consistent with their own welfare.

29 A simple presentation of this idea is in Gruber and Koszegi (2008).

30 Another classic and accessible reference is Schelling (1984). See also Benabou and Tirole (2002).

31 The endowment effect and context dependent preferences in general are examples of preference orderings changing when the economic environment changes. This is inconsistent with standard economic reasoning that separates preferences from opportunities.

32 For a discussion of the efficacy of nudges and the compatibility of the soft paternalism in nudges and normative individualism, see Kirchgasser (2017).

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Steven M. Sheffrin

Murphy Institute, Tulane University (New Orleans).

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