In theory disclosure should solve all market failures. But in theory it’s also easy to definitively identify the source of a common quip about theory versus practice. (More)

Psychology and Policy, Part I: Disclosure, in Theory

This week Morning Feature considers how insights from psychology and behavioral economics should shape public policy. Today we begin with the standard economic theory of disclosure, which libertarians and conservatives often cite as the solution for all market failures. Tomorrow we’ll see how research in psychology and behavioral economics challenges the standard theory, and how that research can improve public policy on disclosure. Saturday we’ll conclude with how insights from psychology could improve our discussion of climate change.

“In theory, theory and practice are the same. In practice, they are not.”

In theory, with tools like the internet, it should be easy to find out who coined that common quote. In practice, you can find sources who attribute it to Albert Einstein, to Yogi Berra, to Chuck Reid, as well as to Jan L.A. van de Snepscheut, William Harbaugh, Alvin Roth, and Karl Marx.

In theory there should be at least once source attributing it to Mark Twain, as Twain is renowned as a quote magnet. In practice I found no one who attributed that quote to Twain. I guess that theory falls to this similar, properly-sourced Twain quote:

How empty is theory in the presence of fact!

In the interests of complete disclosure, that sentence is set in this context:

I read [a draft demand for surrender and promise of forgiveness] to Clarence, and said I proposed to send it by a flag of truce. He laughed the sarcastic laugh he was born with, and said:

“Somehow it seems impossible for you to ever fully realize what these nobilities are. Now let us save a little time and trouble. Consider me the commander of the knights yonder. Now, then, you are the flag of truce; approach and deliver me your message, and I will give you your answer.”

I humored the idea. I came forward under an imaginary guard of the enemy’s soldiers, produced my paper, and read it through. For answer, Clarence struck the paper out of my hand, pursed up a scornful lip and said with lofty disdain:

“Dismember me this animal, and return him in a basket to the base-born knave who sent him; other answer have I none!”

How empty is theory in presence of fact! And this was just fact, and nothing else. It was the thing that would have happened, there was no getting around that. I tore up the paper and granted my mistimed sentimentalities a permanent rest.

Twain presents as “fact” Clarence’s prediction of how the enemy will react to the letter. In context, that sentence does not address the gap between theory and actual outcomes – the argument for which the quote is most often cited.

“Caveat emptor”

Standard economic theory predicts that – because I’ve disclosed there is no definitive source for the quote “In theory, theory and practice are the same. In practice, they are not.” – you will remember and add that caveat when you repeat the quote. Likewise, if you use the Twain quote, you will remember and add the caveat that he did not use it to distinguish theory and actual outcomes.

And since I used the word “caveat” and that’s really a half-quote, for complete disclosure I should provide its full form – caveat emptor – which translates to “let the buyer beware.”

That reflects the idea that people often don’t disclose all relevant information in the course of a transaction, and the information withheld may mislead the other party. Indeed economists of all stripes acknowledge information asymmetry as a potential source of market failure. If people are not fully informed, they cannot make decisions that are fully rational, and the market cannot price and efficiently distribute goods, costs, benefits, and risks. That’s the standard economic theory.

Extreme forms of the theory even argue that markets self-correct for information asymmetries. People who lie or withhold information will acquire bad reputations, the argument goes, and others will refuse to deal with them or demand a better price. That negates the advantage of sharp practice, so in theory – the most extreme form of the theory – everyone will decide it’s better to go ahead and disclose all relevant information.

“More social value than private value”

But the more widely accepted forms of standard theory concede that the market forces will not eliminate all information asymmetries, as George Loewenstein, Cass Sunstein, and Russell Golman explain:

[I]nformation, as a public good, may have more social value than private value and hence be underprovided relative to the social optimum. When there are significant private costs associated with (acquiring or) disclosing information, but benefits are diffuse, no one has an incentive to procure or supply the information. In this case, mandatory disclosure may serve to promote the distribution of socially valuable information.

Let’s assume there are three widget sellers, and all three currently withhold (or may not even gather) some relevant information about their widgets. It might be very expensive for any one widget seller to gather and disclose that information. That seller might lose sales by admitting the flaw when other sellers don’t. Or that seller might fix the flaw and disclose the solution in advertising his now superior widgets, but not gain enough market share to pay for the cost of finding and fixing the flaw … especially if competitors can free ride on his work (“We fixed it too [after he figured out how]!”).

In this situation, that information about widget flaws has “more social value than private value.” Collectively, we might be much better off if the flaw were fixed or at least disclosed. But no seller would fully recoup the costs of identifying and disclosing (or fixing) that flaw.

“Respect for the operation of free markets”

One policy solution for our hypothetical widget problem is for government to require all widget sellers to fix that flaw, what Loewenstein et.al. call “hard regulation.” But increasingly, the preferred policy solution is for government to mandate disclosure:

An important advantage of informational, as opposed to ‘harder’ forms of regulation, is its flexibility and respect for the operation of free markets. Regulatory mandates are blunt swords; they tend to neglect heterogeneity and may have serious unintended adverse effects. For example, energy efficiency requirements for appliances may produce goods that work less well or that have characteristics that consumers do not want. Information provision, by contrast, respects freedom of choice. If restaurant patrons are informed of the calories in their meals, those who want to lose weight can make use of the information, leaving those who are unconcerned about calories unaffected. If automobile manufacturers are required to measure and publicize the safety characteristics of cars, potential car purchasers can trade safety concerns against other attributes, such as price and styling. Disclosure does not interfere with, and should even promote, the autonomy (and quality) of individual decision making. If properly designed, it should also increase efficiency, helping to avoid cases of market failure resulting from incomplete and asymmetric information coupled with misaligned incentives. [Citations omitted]

There are scads of mandatory disclosure regulations. Anyone who’s bought or refinanced a home has signed page after page of documents, at least some of which disclose the relevant details of the mortgage: the principal, interest rate (or initial and subsequent rates for variable mortgages), payment schedule, grace periods, early payment terms, total finance charges, penalties, and so on. Yet in 2008 we saw exactly the kind of massive market failure those mandatory disclosure regulations were supposed to prevent.

Tomorrow we’ll see that research in psychology and behavioral economics reveals limits in mandatory disclosure regulations – including why you probably already forgot the caveats for those pithy quotes above – and how regulations that reflect how we actually learn, think, and behave could make disclosure more effective.

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Happy Thursday!