Nudges and Welfare: Optimal Behavioural Policy with Decision Costs

Abstract

The complexity of the modern world imposes significant cognitive and material costs on consumers. This paper models decision costs to better describe and understand the effects of behavioural policy, and finds that, similar to traditional economic policy, behavioural policies can create welfare distortions and equity-efficiency tradeoffs. In particular, such policies may discourage consumers from optimizing and convince them to take the default even when it makes them and society worse off, an effect I call the discouragement effect. These problems can be minimized through careful policy design, targeting specific subsets of the population to avoid affecting the incentives of others, but doing so efficiently can impose prohibitively high information requirements. This represents one of the first systematic treatments of the welfare implications and tradeoffs of behavioural policy, illustrated in the relatively novel setting of energy-saving technology adoption. Better understanding of the tradeoffs induced by behavioural policies is essential for policymaking.