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A Nobel Prize for a Behavioral Economics Pioneer: Are There Lessons for Regulation?

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Ciudad de México, 21 de junio (Por SCOTT HEMPLING).– Reading these four books causes one to ask: Might the biases discovered by these intellectual eminences affect utility regulation? (I use “bias” not in the conventional sense of having a closed mind, or a predisposition to favor one side of a debate, but rather in the Thalerian sense of having a propensity to make decisions based on irrelevant factors). Among the many biastypes discovered by Kahneman, Tversky and Thaler, consider these three.

Anchoring: Are decisions affected by irrelevancies? Experimenters rigged a wheel of fortune so that it always stopped on 10 or 65. Two separate groups of students were told to watch the wheel spin, write down the resulting number; then guess the percentage of African nations in the United Nations. For the group whose wheel stopped at 10, the average answer was 25%. For the group whose wheel stopped at 65. The average answer as 45%. (Thinking Fast and Slow at 119). The wheel’s number was the anchor; the anchor influenced the guess. Real world implication? “If you consider how much you should pay for a house, you will be influenced by the asking price”. Id. at 122.

When a company proposes a $75 mil- lion rate increase, that number becomes the anchor. Then when the Commission allows an increase of $40 million, its press release says, “We saved customers $35 million”. The anchor influenced the case, the outcome, and the explanation. The an- chored question was: “Has the company justified a $75 million increase?”. The right question is: “What should it cost to supply this service territory?”.

To avoid anchoring —to get the estimate right— one first must detect the anchor, then reduce its influence. Both steps require a clear head: “People adjust less (stay closer to the anchor) when their mental resources are depleted, either because their memory is loaded with digits or because they are slight- ly drunk”. Thinking Fast and Slow at 121-122.

Halo effect: You work for a charitable organization. At a party you meet John, whom you find very amicable. You like John, so you put him on your list of possible donors. But amicability does not equal generosity. You’ve experienced the halo effect, because you associated amicability with generosity —without a speck of data to support the association. You viewed the relationship between amicability and generosity as “simpler and more coherent than the real thing”. Thinking Fast and Slow at 82.

Electricity is awesome, literally: Flip a switch, 500 miles away a puff of smoke appears, your light goes on. Also awesome is utility financing. Tasked with financing new generation and transmission, the CFO somehow coaxes $2 billion from diverse lenders and shareholders. Does our awe of technology and finance, our respect for the CEO’s engineering expertise, cause us to think well of a utility’s rate case request? Anyone who dismisses this tendency is likely underestimating the halo effect. “The sequence in which we observe characteristics of a person… matters… because the halo effect increases the weight of first impressions, sometimes to the point that subsequent information is mostly wasted”. Id. Rather than deny the halo effect, we should acknowledge it—then mitigate it. We can mitigate it by seeking independent sources of information; and, as in good police procedure, prevent these sources from coordinating their testimony. Id.

Narrow framing: A major media hold- ing company owned 23 publications, each run by a separate executive. In a joint meet- ing, Thaler asked each one: If you had a chance to make an investment, one which had a 50% chance of making a profit of $2 million and 50% chance of losing $1 million, would you do it? Twenty of the 23 said no: As one executive explained, success would get him “a pat on the back and a bonus equal to three months income,” while failure could get him fired. The holding company CEO saw it differently: If all 23 made the investments, there would be, based on the probabilities, a total gain $11.5 million. The problem was narrow framing: The holding company’s compensation practices caused each executive to focus only on her situation rather than the total company situation. See Misbehaving at 188.

Are there situations in utility regulation —on the seller or the buyer side—where each individual action (or inaction) makes sense to the actor, but the combination of actions or actions does not? If so, we suffer from narrow framing. Narrow framing also occurs when we base a decision only on the arguments and evidence presented by opposing parties, rather than asking “What would I need to know before I formed an opinion about [this particular issue]?”, Thinking Fast and Slow at 86, and then acquiring all that necessary information.

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Economists initially objected to these discoveries, arguing that rational people cannot be irrational. Tversky responded succinctly: “A theory of vision cannot be faulted for predicting optical illusions. Similarly, a descriptive theory of choice cannot be rejected on the grounds that it predicts ‘irrational behavior’ if the behavior in question is, in fact, observed”. The Undoing Project at 286. Thaler got on his colleagues’ nerves, because he used facts and logic to expose looseness in conventional assumptions. A critic of his profession, he is making it better.

I invite readers to send me examples of how inadvertent biases —as defined here— affect regulatory decision-making. Like Thaler and his colleagues, together we can advance our knowledge and improve our profession.

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SOBRE EL AUTOR:

Is an attorney and expert witness in the United States. He has advised regulatory and legislative bodies throughout North America, and is a frequent speaker at international conferences. Hempling is an adjunct professor at Georgetown University Law Center, where he teaches courses on public utility law and regulatory litigation. His book, Regulating Public Utility Performance: The Law of Market Structure, Pricing and Jurisdiction was published by the American Bar Association in 2013. He has also authored a book of essays on the art of regulation, Preside or Lead? The Attributes and Actions of Effective Regulators. Hempling received a B.A. cum laude from Yale University in (1) Economics and Political Science and (2) Music, and a J.D. magna cum laude from Georgetown University Law Center. More detail is at www.scotthemplinglaw.com.  This article is adapted from remarks presented at the [insert formal name of the conference), Dec. 21, 2015.

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