A large part of economics is based on a false assumption, namely, that people always behave rationally. This means they always maximise their gains and minimise their losses, which, of course, is not true.
So a few years ago, economists came up with a new concept called "bounded rationality". It means that people are rational only within limits. These limits are set by a various factors.
The most important of these is their cognitive capability or ability to figure things out. The stupider you are, the more irrational you will be, says economics.
Sometimes you may be clever but not know enough, as when credit card companies make offers which you accept, only to receive the saving clauses much later.
One of the functions of law is to compensate for this sort of irrationality by extending, as it were, the boundaries of bounded rationality. This is called "debiasing through law".
The objective is to have laws that prevent people from acting against their own self-interest. The question now being asked in the US is how best to do this: through a procedural approach or through substantive law.
In a recent* paper Christine Jolls of the Harvard Law School and Cass R Sunstein of the Chicago Law School say that the latter might be better.
This is because "such debiasing often promises to be more successful and less invasive than more conventional alternatives ... it may be desirable to understand or to reform the substance of law - not merely the procedures by which it is applied in an adjudicative setting - with an eye toward debiasing those who suffer from bounded rationality."
The main idea behind this is not hard to grasp. Instead of raising the costs of irrationality arising from bounded rationality you simply ensure that people don't behave in certain ways or that they behave in certain ways.
This, say the authors, has important implications for, say, the way you allow markets to function. "In some contexts, private actors, alert to the risk of bounded rationality, will take corrective action on their own in the face of bounded rationality, aggressive regulation - some form of 'insulating' strategy - might sometimes be justified."
But would it not be better to steer a middle course, where "legal institutions do not ignore people, but instead to reduce their bounded rationality?" In other words, can you make stupid people act cleverly via the medium of laws?
But what of the other lot, those who are too-clever-by-half such as, say, company directors who cheat shareholders? Independent or outside directors, as opposed to inside ones, are supposed to keep an eye on things, as when the latter show bounded rationality on profit projections or the degree of product risk.
"When inside directors exhibit optimistically biased decision making, one possible response is to insulate the outcomes by removing certain board decisions from the inside directors' hands. By contrast, an approach of debiasing through substantive law would take the form of increasing the number of outside directors on the board."
On a practical level, laws are proposed by governments and made by legislatures. How should they evaluate a law they are considering? Should not an assessment of costs and benefits arising from the law also be made?
The key question to ask to get the right answer is if people can, and are able, to correct their errors. Often they are, and the government need not intervene. A hundred examples spring to mind in the Indian context where the government has butted in needlessly.
The problem is that "bureaucrats use heuristics and are subject to predictable biases; they are also susceptible to the influence of powerful private groups with stakes in the outcome It is certainly plausible to worry that efforts at debiasing by behaviorally sophisticated regulators may operate to reward well-organized private groups, or perhaps to promote the interests of regulators themselves."
How very true.
*Debiasing through Law, NBER Working Paper No. 11738, November 2005
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