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Applying Behavioural Economics to Development Policy

by C. Leigh Anderson and Kostas Stamoulis

Behavioural economics combines the insights of psychology and economics to better understand and predict decision making by considering how, for example, emotions and attitudes (psychological tendencies) influence how preferences translate into choices.

Applying behavioural economics to development policy is a particularly relevant, but neglected, field of inquiry given that in developing countries the poorly educated, the spatially isolated and those in highly risky environments, may be disproportionately represented in the group for whom standard models do not regularly apply—and further, that behaviours may more acutely affect policy outcomes because there are fewer formal institutions, such as credit and insurance markets, to temper their effects.

Despite the growing literature on development policy we are still unable to fully understand how the poor make decisions, especially under uncertainty and over time. It is not clear why, for example, individuals do not regularly adopt subsidized technologies such as ventilated cooking stoves to reduce health risks. They avail themselves less than predicted in health programmes, participate less than expected in market opportunities, under or over insure themselves, and make shortrun decisions that are inconsistent with their long-run welfare. The rise and fall of different paradigms of poor household behaviour can partly be attributed to this limited understanding. We believe that some more helpful answers may lie within behavioural economics, that these insights are particularly important for poor and rural populations, and that they can improve the future design, implementation and subsequent effectiveness of development policies and programmes. 

Though there are many examples that challenge standard economic models we consider three that we find particularly salient for development: decision making under uncertainty, intertemporal choices, and social preferences. 

Decision-making Under Uncertainty

Poor individuals live in risky environments, with fewer mechanisms for smoothing the variability that underlies the uncertainty. How they deal with uncertainty depends on three aspects: the qualitative dimensions of risk, decision rules with known and unknown probabilities, and the framing of choices as gains and losses (reference dependence). We will briefly discuss each.

Individual and social tolerance of a risk depends upon its quantitative and qualitative characteristics, including magnitude, certainty, voluntariness, dread, proximity and distribution of impacts. Individuals systematically overestimate the size of risks that are small, novel, unfamiliar, involuntary and uncertain, and underestimate the size of risks that are more certain, larger, familiar or somewhat voluntary. For instance in Chiapas, Mexico, farmers were willing to pay for local and improved variety seeds that decreased the frequency and magnitude of maize crop loss. Farmers stated a higher willingness to pay to reduce catastrophic loss from drought, and chronic loss from pests, than for exactly the same loss reduction from wind lodging. Our results suggest that the technology with which a crop loss is reduced may be less important in adoption than perceptions of control and dread over the environmental risk causing the loss.

Traditional models assume that individuals make fully reasoned and consistent choices. Yet regular observation and repeated experiments suggest that individuals often employ ‘fast and frugal’ heuristics; rules that allow them to make decisions either in the absence of full information or when they are unable or unwilling to incorporate all the information that is available in the relevant timeframe.

Reference dependence has been regularly confirmed in a variety of experiments. Alternatively attributed to an endowment effect, loss aversion, or a status quo bias, the result is that preferences vary according to the direction of change. In general, individuals are more sensitive to losses than equivalent sized gains—with losses often being weighed more than twice as heavily as gains. Previous questions around insurance behaviour are now attributed to consumers overweighting small probabilities. For developing countries, a recent overview of crop insurance studies concludes that the costliness of informal household risk management strategies imply a positive demand for a fair value insurance contract. Yet crop insurance has been a ‘near-universal’ failure on a financial basis. Common explanations include the covariant risks in agriculture, moral hazard and adverse selection, and insecure property rights. But behavioural evidence also implicates discrepancies between perceived and measured risk. For example, contrary to popular insurance for earthquakes—a vivid and dreaded, but low likelihood event —the higher likelihood, but more familiar crop loss evokes enough risk seeking behaviour to render insurance programs unsustainable.

Intertemporal Choice

Contrary to standard discounted utility models that assume constant discount rates evidence suggests that short-run discount rates, experienced at the moment, are higher than the long-run discount rates we project forward. Hence people with time varying discount rates, if they lack perfect self-control, may pursue shortrun actions that they had previously calculated were not in their best longrun interest—they may consume their savings, fail to stick to a debt repayment schedule, skip school or job training opportunities, exploit natural resources unsustainably, or choose occupations that require little human capital investment.

Standard economic theory posits that individuals can only be made better off with access to credit, since they can always choose not to avail themselves of it. But even with good intent, the optimal payback plan of individuals can change over time, creating repayment difficulties. Naïve consumers, so called because they are unaware of their self-control problems, repeat regrettable behaviours. Sophisticates, on the other hand, can anticipate their inconsistency and seek ways to decrease liquidity and help bind their future behaviour. Evidence from Africa and Asia indicates that relatively simple institutional mechanisms can help align short run choices with long-term preferences, such as lock boxes, money guards, deposit collectors, limited withdrawal savings accounts, and rotating savings and credit associations.​

Social Preferences

Social preferences influence market and exchange behaviour. Repeated experiments suggest that individuals are willing to suffer monetary losses to punish opponents for outcomes or intentions perceived as unfair. Other results suggest that consumers perceive price increases arising from seller cost increases as fair, but not price increases in response to demand fluctuations—and oddly enough, without any information about the base profit levels of the seller.​

Providing for public goods also counters traditional wisdom. For example, studies suggest that people are more likely to contribute to public goods when they believe others are also doing this, even though from an efficiency perspective the marginal social benefits are highest when no one else is contributing.

Conclusion

Though behavioural economics has been slow to penetrate development policy, interest is growing at organizations such as the International Fund for Agricultural Development and the FAO.

The challenging questions for future research, we believe, are around measurement and scale. To be useful, easily measurable correlates of unobservable attitudes need to be found, and the specificity of reference levels and context must be scaled up. And just as institutional perspectives have become part of the mainstream we will eventually overcome our own ‘status quo’ bias about incorporating more psychological realism into our models.​

C. Leigh Anderson is Professor at the Daniel J. Evans School of Public Affairs, University of Washington

Kostas Stamoulis, Chief, Agricultural Sector in Economic Development Service (ESAE), FAO, Rome