Thursday, May 27, 2010

Individual choice Vs transaction costs

One of the most enduring debates in public policy making is in achieving the right balance in providing the widest possible individual/consumer choice without creating unscalable transaction costs in the individual making the most optimum choice. Daniel Hamermesh has this insightful paragraph in the Freakonomics blog about how the individual choice-transaction costs trade-off can often get skewed in favor of the later.

"US bureaucracies seem more flexible than the ones I’ve dealt with in wealthy foreign countries. On the other hand, much less seems to be taken care of for the average citizen in the US than elsewhere — it requires tremendous knowledge and investment of time to get the best deal out of health insurance, Social Security and so many other publicly - or commonly-provided benefits. In wealthy foreign countries, the average citizen is not at much of a disadvantage compared to a knowledgeable, wealthier citizen. In the US, I wonder how the average guy can cope with institutions (or if he can). As in so many areas, we Americans have created a system that allows great flexibility, but that also advantages the better-off. Have we made the right choice in this apparent trade-off?"

These transaction costs arise from two directions

1. Making the most optimal choice from the bouquet of choices presupposes the presence and application of sufficient prior knowledge, both about the general environment and the specific sector, in the individual making the choice. Most often such prior knowledge is a function of the socio-economic status of the individual (which in turn is not fully determined by factors within the control of the individual).

2. Behavioral economists point to Propsect theory and the paradox of choice and the difficulty humans face in making the complex calculations required to make the most optimal choice from among a large number of competing choices.

Therefore, the most under-privileged people who make these choices (and for whom these choices matter the most) do not have adequate prior knowledge and also suffer from the behavioral cognitive biases that constrain them from making efficient choices. It is for this reason that despite, its paternalistic overtones, I am favorably disposed towards the "nudge"-based "liberatarian paternalism" (see this essay examining the new paternalism). This is also a note of caution against blind advocacy of unfrettered consumer/citizen choice in the belief that market dynamics will ensure that the most optimal choices are made.

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