Report

Notes on Behavioral Economics and Labor Market Policy

Linda Babcock, William J. Congdon, Lawrence F. Katz, and Sendhil Mullainathan

Background and Motivation

Recent years have been trying ones for American workers. The unemployment rate has
reached double digits for the first time in over a quarter of a century. Worker compensation
growth has all but stalled. The human costs of labor market turbulence have rarely been
clearer, and the value of public policies, such as unemployment insurance and job training
programs, that assist workers in managing that turbulence, gaining new skills, and navigating
the labor market have rarely been more apparent.

And, even in the best of times, the United States’ labor market is a dynamic and turbulent
one, with high rates of turnover (over five million separations and five million new hires in a
typical month in normal times) but substantial frictions as well. As a result, labor market
programs and regulations are key components of economic policy. Such policies help support
the unemployed, provide education and training opportunities, and ensure the fairness, safety,
and accessibility of the workplace. The challenge for policymakers is to design such policies
so that they meet these goals as effectively and as efficiently as possible.

Labor market policies succeed in meeting their objectives, however, only to the extent
that they accurately account for how individuals make decisions about work and leisure,
searching for jobs, and taking up opportunities for education and training. To a substantial
extent such policies are built around standard economic assumptions of behavior that
individuals are perfectly rational, time consistent, and entirely self-interested. The design of
unemployment insurance with job search requirements intended to minimize distortions to
incentives to return to work, the use of complicated eligibility criteria and administrative
hassle factors to discourage social program participation except for the presumed most needy,
and the shift to vouchers for training services all may be justified by these assumptions.

However, recent research at the intersection of psychology and economics—behavioral
economics—is changing our understating of how individuals choose and act, and with it,
some of our conclusions for policy design. Behavioral economics stresses empirical findings
of behavior that are partially at odds with standard economic assumptions. The key empirical
findings from field research in behavioral economics imply that individuals can make
systematic errors or be put off by complexity, that they procrastinate, and that they hold nonstandard
preferences and non-standard beliefs. (S. DellaVigna, “Psychology and Economics: Evidence from the Field,” Journal of Economic Literature
47
, 2009: 315-72.) To the extent that these behavioral tendencies
operate in labor market contexts, they change both our understanding of the challenges that
policy design must meet, as well as the opportunities and design tools available to
policymakers.

In these notes, we briefly review selected topics in labor market policy though the lens of
behavioral economics. We identify aspects of existing U.S. policy design that appear at odds
with behavioral findings, as well as unrealized policy opportunities those findings suggest.
And we make recommendations for either policy reform or further study, according to what
the evidence supports. The results of this review are prescriptions for policy design and
innovation that reflect a synthesis of traditional and behavioral economic insights. We
consider implications of behavioral findings in three areas of labor market policy:
unemployment insurance, job search assistance, and job training.

Some of the implications of behavioral economics for policy are overlooked in traditional
formal economic analysis but reflect what might best be called “common sense” and are
similar to the critiques and prescriptions of many long-time policy practitioners and analysts.
These include common-sense recommendations to reduce the fragmentation and complexity
of U.S. job training, employment, and social welfare programs. The behavioral approach
also provides a reinterpretation of traditional labor market policy proposals such taking into
account loss aversion and potentially biased wage expectations in considering the case for
and the design of wage-loss insurance policies. And behavioral findings from other domains
generate new insights related to the choice architecture and choice platforms for helping
guide unemployed and disadvantaged workers through training and education options. (R.H. Thaler and C.R. Sunstein, Nudge, Yale University Press, 2008)

Overview of Recommendations for U.S. Labor Market Policy

A review of the intersection of behavioral economics and current U.S. labor market policies
leads to two categories of policy recommendations: Where the research is sufficiently clear
and informative at the appropriate level of detail, it directly suggests changes to policy.
Where the promise of behaviorally informed policy changes is clear but the specific policy
implications are not, it suggests demonstration and evaluation projects.

1.1 Recommendations for policy reform

  • Unemployment compensation. Should include wage-loss insurance in some form. In
    addition to the insurance benefits it provides, wage-loss insurance offers a way of
    assisting individuals with the psychological adjustment to changing labor market
    conditions and addresses likely biases in wage expectations that impede work incentives.
  • Employment services and job search assistance. Should be expanded to provide more
    accessible and meaningful information about labor market conditions and occupational
    projections. These programs should help address procrastination in job search and
    provide guidance to unemployed and low-wage individuals in a way that both reflects
    and takes advantage of the way people process information.
  • Job training. Should simplify program take-up, navigation, and completion, and provide
    user-friendly information on the quality of training providers. These programs should
    structure choices to reflect the limited abilities of individuals to manage complexity and
    exert self-control.

1.2 Recommendations for future investigation

  • Unemployment compensation. Should experiment with alternative incentives for
    encouraging workers to return to employment that reflect their propensity to procrastinate
    job search. For example, the unemployment insurance system should test the use of
    small, high frequency bonus payments that are contingent upon events other than finding
    employment and retaining a job for many months.
  • Employment services and job assistance. Should study the impact of counseling with the
    goal of debiasing beliefs and alternative framings of employment opportunities that
    address reference dependence. For example, tests of alternative methods of debiasing
    wage expectations.
  • Job training. Should experiment with choice platforms in which providers compete to
    offer services, as a way to encourage innovation in meeting the needs of worker with
    limited capacity for managing complexity. For example, by creating markets for advice in
    which providers are rewarded based on meaningful performance measures (employment
    and earnings outcomes) instead of just the use of services.

The remainder of this paper describes these recommendations, and their justifications, in
more detail.