I think one of the most important tests of behavioral economics will arrive in the next few years, as we attempt to persuade consumers to improve energy efficiency in the home. Just imagine if, instead of installing granite on every kitchen countertop, we’d instead spent that money on better window seals and insulation. Of course, if people were rational agents, we wouldn’t need cleverly constructed “choice environments,” since the vast majority of efficiency improvements pay for themselves with reduced energy bills within a few years. (According to Energy Star, buying more efficient appliances, such as SEER 13 air-conditioners, can reduce energy usage by those appliances by nearly 30 percent. For instance, the incremental cost of a SEER 13 unit relative to a SEER 10 unit – that’s the current minimum allowed – is about $170. However, the average household will save nearly $50 per year in electricity costs, which means that the higher standard pays for itself in less than four years.)
So what’s the trick? How can we re-engineer human behavior? I think we’ve picked off the low-hanging fruit by redesigning those Energy Star labels, so that it’s now clear to shoppers in WalMart that buying the slightly cheaper water heater will lead, over time, to significantly higher heating bills. The same goes for air-conditioners, washer/dryers and refrigerators. Sometimes, better decisions result from more transparent information, so that people can translate abstract measurements of energy (watts, amps, etc.) into dollar amounts on an energy bill. If we’re asking people to make short-term sacrifices for long-term benefits, then we have to make those benefits more tangible.
But I’m not sure this approach is sufficient when it comes to the big and necessary improvements, which require a home retrofit that can cost thousands of dollars. Sure, there are hefty tax incentives but not everyone can benefit from a tax deduction. At moments like this, we need less asymmetric paternalism and more good ol’ fashioned liberal paternalism. In other words, it’s time for regulation.
The challenge, of course, is designing a regulation that dramatically increases home energy efficiency without pissing off homeowners. Here’s where behavioral economics comes in handy. One of my favorite human biases is what I call the “Ritz internet blind spot”. Isn’t it odd that fancy hotels can charge $12.95 for the internet but every Best Western gives you the internet for free?
The explanation for this consumer quirk has to do with something called mental accounting, which was first explored by Richard Thaler. For example, when Thaler asked people whether they would drive 20 minutes out of their way to save $5 on a $15 calculator, 68 percent of respondents said yes. However, when he asked people whether they would drive 20 minutes out of their way to save $5 on a $125 leather jacket, only 29 percent said they would. Their driving decision depended less on the absolute amount of money involved ($5) than on the particular mental account in which the decision was placed. If the savings activated a mental account with a miniscule amount of money⎯like buying a cheap calculator⎯then they were compelled to drive across town. But that same $5 seems irrelevant when part of a much larger purchase. This principle also explains why car dealers are able to tack on unwanted extras and why expensive hotels can get away with charging six dollars for a can of peanuts and $12.95 for twenty four hours of internet. Because these charges are only a small part of a much bigger purchase, we end up paying for things that we wouldn’t normally buy.
What does this have to do with home renovations? Here’s my proposal: when a home goes on the market, it should be tested for energy efficiency. If it doesn’t meet some basic standards, we should require an energy efficient retrofit before the home is sold. (Obviously, we can scale the regulations so that the mandate varies with purchase price. As a taxpayer, I’m willing to subsidize the retrofit of cheaper homes. That also seems like a useful way of generating green jobs for relatively unskilled workers.) But I can already hear the naysayers: Won’t homeowners object? Won’t that just add thousands of dollars to the cost of buying a home?
Enter mental accounting, an irrational bias that can be tweaked to produce positive outcomes. Because a home is already such a gigantic purchase, and because the home buying process is already so saturated in peculiar fees (inspection charges, loan points, escrow fees, mortgage broker expenses, etc.) I’d argue that consumers will be much less sensitive to the cost of a home renovation. They’ll barely even notice the $5000 “energy efficiency charge” when it appears on their massive bill from the real estate agent. (Besides, they’ll get a big chunk of the money back as a tax credit.) In other words, they’ll act just like me the last time I stayed at a fancy hotel, when I ordered the internet and ate the peanuts.