Why consumers should resist the enemies of choice

The recent Australia Institute report into the nation's personal finances made for pretty depressing reading.

According to the report, prepared for the Citi Australia bank, few Australians research big financial decisions properly and many are unable to recall important financial information such as their home-loan rate. Many also construct their finances in apparently irrational ways, for example by failing to pay their credit cards in full on time, even when they have savings.

The report builds on a growing and increasingly popular field of economic research known as behavioural economics. Behavioural economics strives to incorporate understandings of human behaviour from the field of psychology with traditional economic survey techniques.

Much of the research so far argues that humans often behave in ways contrary to assumptions made by traditional economists.

The alleged findings of behavioural economics are significant because the assumption that humans rationally seek to maximise their welfare is a cornerstone of most of modern free-market economics.

The move away from central planning and towards a freer, more open economy was in part due to the work of economists such as Milton Friedman and Friedrich Hayek, pejoratively labelled neo-liberals by many on the Left, who recognised the efficiency and wisdom of allowing individuals to pursue their self-interest freely.

Although the report shied away from prescriptive policy recommendations, the Australia Institute's views on regulation and the role of government in the economy are well publicised elsewhere.

Whether it is the banking industry, the environment or advertising unhealthy products such as alcohol and junk food, it hardly seems there are any social problems that the Australia Institute believes cannot be solved with a little extra government regulation.

So it is no surprise it has jumped gleefully on the behavioural economics bandwagon, believing — as many do — that it undermines decades of economic policy.

Critics of free-market economics contend that as individuals often behave irrationally, policy decisions such as deregulating industries, reducing barriers to trade and privatising publicly owned assets may have been misplaced. As The New York Times put it: "If the behaviourists prevail, the mainstream view of a rational, self-regulating economy may well be amended and policies adopted to control irrational, sometimes destructive behaviour. Twenty-five years of deregulation might lose its appeal."

Ross Gittins, Fairfax columnist and economist, argues, "When you accept that individuals are far from rational you open up the possibility that governments may well be better judges of what is best for the individual."

The recent financial crisis provided more ammunition for free-market critics, who argued it was yet more evidence that individuals could not always be trusted to make the right decisions, and that the steady hand of government was required to ensure optimal outcomes.

A central focus of behavioural economic research has been the idea of choice overload. That is, individuals are often overwhelmed by the wide array of options available to them, and this leads to poor decision-making or decision paralysis.

In one of the most celebrated pieces of behavioural economics, two researchers found higher levels of satisfaction from study participants whose choice of luxury jams was restricted to a few varieties, compared with those who could choose from many more options.

Other economists have not been able to replicate the findings, which also appear to be contradicted by real-world evidence, considering the companies that have prospered by offering consumers more choice and variety.

The financial turnaround of McDonald's earlier this decade has been attributed at least in part to offering more options to consumers and one of the world's fastest growing franchises, Subway, has constructed its business entirely on the basis that consumers value choice in what they eat.

Nevertheless, the policy solutions seem clear to behaviourists.

Richard Thaler, one of the most significant economists in the field, advocates restricting Americans' choice of retirement fund providers to two or three — from potentially thousands of options — lest they make sub-optimal investment decisions.

This leads to an obvious question: who should be entrusted with the decision to restrict our choices?

Surely not elected officials. If it is true, as the behaviourists would have it, that humans are flawed and prone to irrationality, presumably this includes individuals who happen to be elected to high office.

Even if they were somehow exempt from irrationality, we should not forget they are elected, and usually hope to be re-elected, by the supposedly irrational masses, which may skew their priorities in office.

Indeed, it requires quite a feat of intellectual flexibility on the one hand to argue that all humans are prone to irrationality and simultaneously to believe that the answer is to entrust other humans to regulate this irrationality out of existence.

The unintended consequences from governments using regulation to restrict choice are potentially immense.

After all, the supposedly debilitating range of options we are able to choose from are available to us only as a result of firms competing for our dollars. Restricting our capacity to choose will also restrict their incentive to innovate and would likely lead to lower quality products.

Free-market economics, and the idea that individuals are best placed to make decisions in their own interest, will always face attack from those who believe society would be better if experts were running the show.

Those who are sceptical of the virtue of individual liberty have become more sophisticated through time in their criticisms.

Old-fashioned Marxists argued people were being manipulated and taken advantage of by a ruling class of capitalists. Keynesians suggested that economies ran best when they were directed from the top, rather than allowed to grow organically.

Modern behaviourists have adopted a scientific veil to argue that humans are fundamentally irrational and that society would be better off if these irrationalities were controlled.

But it is not clear that people are as wildly irrational as they claim. Even if they are able to prove conclusively that individuals are so irrational that they can't be trusted to run their own lives, surely the answer is not to hand power over their lives to equally irrational policy-makers.

The philosophy of individual liberty has faced substantial threats in the past, but no alternative worldview has demonstrated that it can generate wealth and prosperity on the same scale as granting individuals freedom to choose.

James Paterson is a columnist for The Spectator Australia and author of ‘Too Much Choice?’ in Policy magazine (Summer 2010).