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Lessons from Behavioural Economics for Development Policy

23 April 2014

Jukka Pirttilä​

In conventional economic theory, agents are assumed to be able to make rational choices, unaffected by emotions and not constrained by decision-making errors. This theory works well in some situations, but in the last two decades, it has become increasingly clear that the theory also fails in providing guidance in many important strands of economic decision making. The insights of behavioural economics have begun to be applied to development economics also, and in particular to the behaviour of poor households in poor economies. Does poverty promote departures from the standard text book model of rational choice? Are the departures from conventional models different in developing countries than in developed economies and are they possibly also more important when the decision makers are poor? And what policy interventions are appropriate for growth and poverty reduction in such a world?

An open access special issue of the Review of Income and Wealth, which is now published as the first issue of the journal in 2014, deals with these questions.

In conventional economic theory, agents are assumed to be able to make rational choices, unaffected by emotions and not constrained by decision-making errors. This theory works well in some situations, but in the last two decades, it has become increasingly clear that the theory also fails in providing guidance in many important strands of economic decision making, such as savings and investment behaviour, consumption choices (of addictive substances, for instance), and redistributive preferences. Therefore, the ‘imperfections’ of individual choice behaviour are increasingly accepted by the profession as viable empirical phenomena to be explained and incorporated into economic theory. Non-standard objectives and decision making—procrastination; overweighting low probability outcomes; focus on changes from current wealth as a reference point; willingness to sacrifice returns for fairness of process or outcome, etc.—have been investigated theoretically, empirically, and experimentally.[1]

The insights of behavioural economics have begun to be applied to development economics also, and in particular to the behaviour of poor households in poor economies. Does poverty promote departures from the standard text book model of rational choice? Are the departures from conventional models different in developing countries than in developed economies and are they possibly also more important when the decision makers are poor? And what policy interventions are appropriate for growth and poverty reduction in such a world?

With this backdrop, UNU-WIDER organized a project on ‘Poverty and Behavioural Economics’ to take stock of current knowledge, to draw out major policy implications, and to chart promising areas for research. A wide range of papers were presented at a conference in Helsinki in 2011, and some of them were selected for a special issue of the Review of Income and Wealth, which is now published as the first issue of the journal in 2014, and is open access.[2]​

The opening paper in the issue, ‘Behavioral Design: A New Approach to Development Policy’ by Saugato Datta and Sendhil Mullainathan, present a new way of conceptualizing the contribution of behavioural economics by emphasizing the scarcity of a resource ignored by conventional theories of rational choice. This is the scarcity of mental resources—attention, understanding and cognitive capacity are not infinite, nor is self-control unlimited. These features of the human mind explain behaviour which would otherwise appear ‘irrational’ in terms of the standard theory.

With this background the authors propose a general framework for policy intervention that proceeds from diagnosing the root of the problem to identifying bottlenecks, to testing potential remedies using careful evaluation, and then scaling up those solutions with proven impact. They suggest a number of principles for policy design, including reducing the need for self-control (e.g. by making payments in smaller units rather than in large sums), the use of commitment devices to overcome self-control problems (e.g. by providing restrictive bank accounts), choosing default options intelligently (e.g., making automatic transfer into a saving account the default option), recognizing the power of micro-incentives (e.g., giving a small amount of grain as a reward when a child is brought to an immunization center), not being shy of continual reminders (e.g. to make deposits into savings accounts) or paying attention to the framing of government messages (e.g. emphasizing what people lose by not participating in a programme rather than by stating what they gain).

One of the most traditional problems in development economics is the issue of potential under-saving by the poor. Another paper in the special issue ‘Savings By and for the Poor: A Research Review and Agenda’, by Dean Karlan, Aishwarya Ratan, and Jonathan Zinman, is devoted entirely to the savings question, focusing on the insights that a behavioural perspective can provide to analysts and policy makers. The paper investigates five types of constraints on savings in poor countries—transaction costs, lack of trust, information gaps, social barriers, and a range of behavioural biases. The authors review what is known on these issues and set out a research agenda for the future. The recommendations are numerous, but just to pick one: the authors emphasize the importance of simplifying financial literacy programmes to increase their effectiveness, but they point out that we need to investigate the features of successful cases in greater detail—content, length, pedagogy, the nature of delivery and which member of the household the program is delivered to.

Commitment devices, such as monthly savings placed in a secure account, in savings enhance women’s ability to resist family pressures. We need to know more about how exactly household savings decisions are made and how the availability of commitment devices affects broader norms of sharing through social networks. In their paper ‘Social Capital, Network Effects, and Savings in Rural Vietnam’, Carol Newman, Finn Tarp, and Katleen van den Broeck focus on information failures and social networks in savings. Active participation in Women’s Union is used as a proxy for social networking, and it emerges that membership in a highly connected network leads to higher savings and better use of such savings. One policy conclusion is that transmission of information on savings products through organizations like the Women’s Union could be an effective channel for enhancing savings in rural areas. Another is to make sure that the quality of information disseminated via these informal channels is sufficiently high.

The issue of trust is present not only in savings behaviour, but more broadly in collaboration. In ‘Aid Distribution and Cooperation in Unequal Communities’, Ben D’Exelle and Marrit van den Berg link distributional considerations with co-operation in a behavioural perspective. The study is motivated by the purpose of understanding how different ways of allocating aid to communities affects the overall value of resources (aid and production) and the distribution of those. The authors conducted a trust game (where contributions are gathered to a common pool and the proceeds are then distributed according to pre-determined rules) in rural Nicaragua. They found that when the pool is distributed by the highest contributor, the contributions to the pool are higher than when the rule is that the pool will be distributed equally. However, it is also found that the highest contributors, when given the common pool to distribute, do not keep it all to themselves. They seem to have fairness considerations strongly in mind—they give higher amounts to those with lower endowments, and lower amounts to those who contributed relatively small amounts to the pool.

Distributional issues are studied by other papers in the issue, in one linking distributional valuation from surveys to actual country-level redistribution taking place, and in others by developing new measures of poverty, vulnerability, and inequality when individuals’ preferences are reference dependent, meaning that individuals’ wellbeing depends not only on their own current income but also on their earlier income levels and the income of others in society. More work on applying these measures in welfare measurement will be included in the current work programme of UNU-WIDER.

Jukka Pirttilä is Research Fellow at UNU-WIDER.



[1] The award of Nobel Prizes to Daniel Kahneman and Vernon Smith, of the Clark Medal to Matthew Rabin, Esther Duflo and Raj Chetty, and of the MacArthur Award to Michael Kremer, Sendhil Mullainathan and Esther Duflo have confirmed the recognition of behavioural economics as an important new departure in economics.

[2] The 2015 World Development Report, ‘Mind and Culture’, will also be devoted to the topic. 
 

WIDERAngle newsletter
April 2014
ISSN 1238-9544

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Bringing in Public Economics – An Interview with Jukka Pirttilä
Bringing in Public Economics – An Interview with Jukka Pirttilä
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Information asymmetries in extractive industries
In the second part of this blog, Alan R. Roe discusses what is known about the informational failures that pose challenges for governments in projecting revenues from extractive industries. Read the first part here ...
Information asymmetries in extractive industries