Behavioral Economics and its Applications. Edited by PETER DIAMOND and HANNU VARTIAINEN

In recent years, behavioural economics (BE) has moved beyond documenting systematic deviations from the traditional economic modelFcomposed of selfish and unboundedly rational agents with unbounded willpowerFand has begun the process of formulating models that capture these deviations, thus allowing a more careful examination of their economic implications. This book attempts to identify specific settings where the application of BE is likely to be valuable. It contains thoughtful discussions of six areasFpublic economics, development economics, law and economics, wage setting, health economics and the economics of organizationsFwritten by some of the leading researchers in these fields. The book, which has its basis in a 2004 conference, also contains insightful commentsFboth general and chapter-specificFfrom a very impressive set of scholars. Most of the chapters are exploratory in nature and contain reviews of important open questions as well as of findings from the BE literature which may prove useful in tackling these questions. The chapter on public economics is written by Douglas Bernheim and Antonio Rangel. They begin by surveying their work on the possible rift between positive and normative analysis raised by findings in BE, and potential ways of addressing it. This is a fascinating discussion that goes to the heart of the neoclassical approach. How are we to apply the principle of revealed preference when observed choices are context-dependant or when they appear to be ‘mistaken’? One intriguing possibility is utilizing neuroscience to identify circumstances under which a neural process necessary for decision making malfunctions. This suggests the possibility of retrieving preferences from choice by selectivelyFyet in a disciplined wayFapplying the revealed preference principle. Bernheim and Rangel examine three applications: saving, addiction and public goods. Sendhil Mullainathan points to the potential importance of BE findings for understanding some of the hurdles facing developing countries. In particular, education and saving decisions may be better understood given what we know about bounded willpower. Christine Jolls discusses behavioural law and economics. She starts by considering the Coase theorem and the challenge posed by the endowment effect, namely that the assignment of entitlements may itself affect valuations. Jolls then surveys evidence on judgment errors important for legal systems, and discusses several interesting applications such as distributive legal rules. She concludes by reviewing the new project (largely due to Jolls and Cass Sunstein) of ‘debiasing through law’ which, rather than designing laws that take into account given behavioural biases, seeks to reduce these biases by carefully changing the legal environment in which individuals operate. Truman Bewley considers survey and experimental data that may shed light on the process of wage setting, particularly downward wage rigidity. Interviews with managers suggest that resistance to wage cuts comes mainly from upper management. The key reason is that pay cuts damage ‘morale’, a concept that Bewley explores at some length, distinguishing it from job satisfaction and trying to grapple with its determinants. Interestingly, employers tend to dismiss both Akerlof’s (1982) gift exchange model and Shapiro and Stiglitz’s (1984) ‘no shirking’ theory: they see little persistent connection between increased pay and morale, and claim not to obtain cooperation by threatening to fire shirkers. Experimental evidence tends to agree with much of what managers say, in particular with respect to perceived fairness and negative reciprocity. Gift exchange experiments do reveal a tendency to reciprocate high wages with high effort, but Bewley suspects that habituation is likely to make this response short-lived. Richard Frank offers a compelling argument that if there is a field that cries for the application of BE, it is health economics. Both patients and physicians have to make decisions under considerable uncertainty and stress. Evidence suggests that physicians often form their beliefs, and act, based on small samples, local practice, habits and professional norms. At the same time, patients rely heavily on friends and family as well as on their usual, familiar, doctor for information. And as Arrow noted 45 years ago, trust seems to play a central role in doctor–patient relations. These and many other features of the health sector surveyed in this chapter suggest that important progress can be made by introducing behavioural insights to the study of this field. Finally, Colin Camerer and Ulrike Malmendier consider the economics of organizations. They start by pointing to several possible modifications to the workhorse principal-agent model, suggested by BE findings (e.g. allowing workers to care about the procedure that generates their wages or to evaluate wages using reference points). The equilibrium properties of many of these 404 ECONOMICA [APRIL