Nicholas Baigent (LSE): “Revealed Welfare, Nudge Confirmation and other Public Policy Interventions in Behavioral Economics: A preference reversal result”

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Abstract: Inferring welfare from choice has long been a central issue in choice theory and provided foundations for public policy interventions. Rational choice theory assumes that choices are induced by optimizing a preference where the preference also represents welfare. However, Behavioral Economics robustly rejects the preference optimization assumption while often attempting to retain welfare-based justifications for public policy. For example, nudge theory imposes a definitional requirement that nudges raise welfare. Thus, the foundational question in behavioral welfare economics is: What can be inferred about welfare from choice alone without assuming anything about the determinants of choice behavior? Bernheim & Rangel (2009), after offering two related answers, reject one on the grounds that it will sometimes fail to establish which available alternative has the highest revealed welfare. However, it does not always fail. Thus, the question arises: When it does not fail, is it then OK or does it have other problems? A simple model of boundedly rational choice is developed to address this question, based on some remarks in Sunstein (2015). It is shown that, in this Bounded Rationality model, the choice-based welfare ranking rejected by Bernheim & Rangel may reverse the “true ranking” of the chooser. This preference reversal has some general significance for behavioral welfare economics, and a particular one in nudge theory for the following reason: Definitionally, an intervention fails to be a nudge unless it it may be confirmed that it is welfare enhancing. But that requires welfare revelation from choices,  and the preference reversal draws attention to a possible problem in using some of Bernheim-Rangel’s analysis for this purpose.