Economics has been called the dismal science. The term implies that left on their own, individuals will adopt, or retain, behaviors that may be good for them, but will lead to suboptimal social outcomes.

One of the most fascinating areas of economic research today is called behavioral economics. It is the study of how people make decisions and is used to explain why people become addicted to drugs, commit property crimes, or gamble against poor odds. It’s not just used for explaining bad behaviors. Behavioral economists also use their theories to explain why people marry, landscape their yard, or perform altruistic acts.

This research into the effect of behavior on economic decision-making actually has important policy implications. For instance, in 2006 Congress changed the rules for defined-contribution retirement plans known as 401(k)s. Prior to the change, most plans were opt-in, meaning employees had to choose to participate in the plan. The change in rules allowed companies to automatically enroll all new employees in the retirement program (into a safe investment as defined by the U.S. Dept. of Labor) unless they chose to opt-out.

Traditional economic theory says that the desire to invest in a retirement plan should be independent of whether the employee has to choose to opt-in or opt-out of the plan at the time of hire. And yet behavioral studies show people tend to prefer to do what everyone else is doing, or what an authority figure says is best. Data collected from firms that switched from opt-in to opt-out show that participation rates rise, from 40 to 70% when employees had to opt-in, to over 90% after adopting opt-out.

Richard Thaler, a leader in the behavioral economics movement, calls it “libertarian paternalism.” That is, the goal is not to restrict choices, but to offer them in a way that leads to better outcomes. Another way to increase retirement savings that Mr. Thaler promoted, and convinced Congress to accept, is called Save More Tomorrow. He is also one of the coauthors of Nudge, a great book on how to improve your decision-making skills. [Disclosure: I am a graduate of Univ Chicago’s Booth School of Business, where Mr. Thaler teaches.]

Nudge

Nudge: Improving Decisions About Health, Wealth, and Happiness. Image from Amazon

Last week, my wife pointed me to an article in the New York Times that shows how behavioral economics research is now being used to “improve” the effectiveness of political campaigns. One of the most influential groups in the 2008 presidential campaign by Barack Obama is called the Consortium of Behavioral Scientists. One of the members is Mr. Thaler. You may recall that Mr. Obama taught constitutional law at the Univ. of Chicago and was already quite familiar with Mr. Thaler’s work.

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