Nudges, Mandates, and Taxes: Policy Design with Active and Passive Decision-Makers

Abstract

Growing evidence suggests that many people are surprisingly responsive to unconventional policy tools, such as defaults or choice-framing, yet unresponsive to conventional ones, such as taxes or subsidies. This paper studies the optimal choice of policy instrument in settings characterized by such features. We utilize a simple binary-choice model in which decision-makers are either active or passive; active choosers make their decisions by comparing perceived costs and benefits whereas passive choosers select whichever option is the default. From this simple model, a number of results emerge. First, manipulating the default option (“nudging”) is preferable to imposing a mandate when active choosers tend to make correct decisions. Second, taxes and nudges are complements, not substitutes; employing the two types of instruments in conjunction can yield better results than utilizing either one alone. Finally, the optimal combination of taxes and nudges is typically preferable to a mandate even in settings where active choosers are prone to biases. The results establish important limits on the range of settings in which mandates are an efficient policy response to decision-maker errors.