Case study:

Market Failure and the Framing Effect

• Behavioral economists agree that in a world of bounded rationality, people can end up making
decisions that they later regret. This can be a product of a choice environment that induces
them to make choices that they would eventually consider to be an error in judgment.

• Market forces often fail to repair the frame or fix the default option. The choice environment
becomes distorted, producing choices that aren’t always in line with people’s preferences.

• Such choices are inefficient, suboptimal, below par in regards to people’s own benchmark of
what’s the best choice.

• This situation represents some sort of market failure — but market failures can be corrected.

• Market failure is a situation in which the free-market solution to an economic problem can be
improved upon. The invisible hand of the market can’t do it all.

• A classic example of a market failure is pollution. Pollution is, in part, a product of individuals
who are out to maximize profits, acting on the incentives provided by market forces. People
pollute because market prices don’t force them to internalize the pollution costs that they’re
imposing on others. Frames generate market failures when they provide false or misleading
signals to people, inducing them to make choices that they wouldn’t otherwise make. Frames
can distort people’s choices.

• Touse a term coined by American economist David George, people’s preferences become
polluted — we end up with preference pollution. More precisely, in this case, we end up with
choice pollution. Economists of all stripes recommend some form of government intervention to
fix market failures. Conventional economists have been at the forefront when it comes to
articulating public-policy questions dealing with market failure. But the possibility that the
framing aspects of the choice environment can contribute to market failure hasn’t been part of
the economics toolbox.

• Although there are differences of opinion among behavioral economists on the extent to which
framing distorts choices and causes errors in decision making, there is agreement that framing
affects the choices people make. But there is disagreement on the extent of ntervention that
should take place to correct for market failure. Many behavioral economists call for more
pervasive government and expert intervention because they assume that people are easily
misled by the choice environment in general and frames in particular and don’t have a strong
sense of what’s in their own best interest. They argue that choice architects should help correct
people’s error-prone behavior by nudging them (and sometimes driving them) to do what the
experts think is right.

• Other behavioral economists argue that, for the most part, people are smart decision makers
who make the best possible use of their choice environment (including frames and defaults) to
 make smart decisions and to correct identifiable errors in decision making. Sometimes, what
appears to be a dumb decision is a product of smart choices being priced out of the market.
Other times, people lack the economic literacy needed to make the best possible decisions. But
errors in decision-making can take place because of distortions in the choice environment,
which can include false and misleading advertising, as well as defaults that are misleading,
hidden, or poorly thought out.

• Governments and experts can help fix this problem by ensuring that the information that people
use to make choices is up to the task. Defaults need to be designed so that they don’t mislead
and deceive and meet, at a minimum, the preferences of most decision makers. If people are
weak in their computational abilities and their understanding of economic concepts, this also
can result in errors in decision making. But this problem can be addressed by improving people’s
level of understanding and by assuring that the choice environment works for people’s level of
understanding and education.