FORTUNE -- Much of economics is based on the simple idea that people prefer cheaper products to more expensive ones. But what if that's not always the case?
Those working within the blossoming field of behavioral economics have explored the ways in which humans function (or don't, as the case may be) as rational actors, and new studies show just how bad we can be at making the best decisions for ourselves. One such working paper, published Monday by the National Bureau of Economic Research, looks at the strange decisions Americans make when it comes to purchasing, of all things, water heaters.
Why water heaters, you ask? The authors of the paper, economists Hunt Allcott and Richard Sweeney, chose this item because the sticker price of water heaters varies considerably based on how energy efficient they are, and the total cost of the product requires consumers to understand both the sticker price and the price of the appliances' energy use over time. The authors say water heaters are a good subject for study "precisely because they are so mundane. Consumers rarely think about their water heater until it breaks unexpectedly, at which point they want to replace it quickly, with limited time for search and information acquisition."
This is the logic behind the "Energy Star," a program in which companies submit their products to the EPA or Department of Energy for efficiency testing, and products that meet certain energy requirements get the "Energy Star" seal. Many of these products are so efficient that even though they are have higher sticker prices, they actually are less expensive for the consumer in the long run. Labeling these products as "Energy Star" products helps close the information gap for consumers who want to act rationally and buy the truly cheaper product.
But Allcott and Sweeny's work calls into question whether the Energy Star label encourages consumers to buy the least expensive (in the long run) product. The economists embedded themselves with a "large nationwide retailer" that sells about 45,000 water heaters every year. They studied the buying habits of roughly 20,000 potential customers who called about water heater purchases, examining how sales of energy-efficient models were affected by heavy incentives like $100 rebates for customers and $25 sales incentives for salespeople who sold energy-efficient models. They found that even with the rebates, which often increased the typical customer's return on investment to 28% t0 37%, customers overwhelming chose to buy a water heater with a lower sticker price.
Consumers have an irrational bias against high upfront costs, even when they are aware that the cost of the product will be cheaper in the long run.
The study's findings also have implications for policymakers. Consider the public battle over incandescent lightbulbs. In 2007, President George W. Bush signed the "Energy Independence and Security Act of 2007," which, among other things, banned the manufacture of most incandescent light bulbs in use at that time because they were too energy inefficient. Despite industry innovation in the light bulb market that reduced the total cost of lighting (bulb and electricity included), customers still went for the cheap and familiar incandescent bulbs they were used to. They needed to be nudged into submission to opt for the energy-efficient bulbs.
Yale economist William Nordhaus has studied the economics of climate change extensively, and sees "energy-cost myopia" as a prime reason the government should regulate markets for appliances. In his recent book The Climate Casino, Nordhaus compares regulations that require efficient products to those that require cars to include airbags. "Since people do not always behave in their long-run self interest, careful use of regulatory mandates can save lives (in the case of airbags) or money and CO2 emissions (in the case of effective energy regulations)," he writes.
This is the justification for many government programs, from Social Security to unemployment insurance. People don't always behave in their best interests, and despite the high-profile complaining about the disappearance of certain lightbulbs, we're all better off without them.
The government cleared the use of ethanol-rich gasoline in late-model cars and trucks.
The Environmental Protection Agency approved the sale of so-called E15 fuel – comprising 85% gasoline and 15% ethanol, which is made in this country largely from corn – for use in cars and trucks made since the 2007 model year.
The EPA said the decision clears the first step toward full-scale commercialization of E15 blends. Until now, ethanol MOREColin Barr - Oct 13, 2010 1:51 PM ET
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