Where Poverty and Behavioral Economics Meet

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SEATTLE — Economics as a field informs policy legislation in every country. As an important facet of public policy, an understanding of economics is vital to helping the poor. By understanding market forces as well as incorporating other social sciences, public policy can maximize its intended goals of creating higher levels of societal social welfare.

But what if the economic theories underlying the public policies are flawed? Economics often uses basic assumptions to build models and understand phenomena. One of the most important assumptions is that people are perfectly rational decision-makers. This is clearly a flawed assumption to make; people do not always act rationally. For example, take “framing,” depending on the way one phrases a question a person may answer differently, even if the question is essentially the same either way. The framing effect is an example of irrational decision-making.

Behavioral economics is an emerging field of study that models a person’s decision-making while taking into account psychological irrationalities such as the framing effect. By accounting for these irrational behaviors in economic theory it might be possible to produce what would be a more accurate representation of a person’s choices.

Since public policy is informed by economics, and economics is flawed by faulty assumptions, it follows that using behavioral economics to understand people’s decision-making rationales is a good way to endow policies with greater understanding of how they will work in reality.

To begin with, poverty has been shown to have the ability to impede cognitive ability, which could by itself affect the decision-making of those who are impoverished. This may cause even more exaggerated impact from already normal cognitive biases.

A study referenced in “A Behavioral-Economics View of Poverty” suggests that money that is “accounted” and in a bank account is more likely to be saved than money that is more easily available and is not “labeled” (for example, a savings account) or set aside for something else.

This result could help inform public policy by creating measures that would increase the abilities of the poor to have access to banking services. If the poor had access to these services, they may be more likely to save money if they can, and in the long term, this could be helpful. Although this example is based off the assumption that the poor have money to spare, which in many cases is not true, measures such as these could help the poor as they begin to move into higher socio-economic status and need to practice more long-term financial planning to avoid sliding backwards.

The Economist had an example of a transfer program in Bogota, in which behavioral economics was used to increase the effectiveness of the policy. The cash transfers were given each month on the condition that the children were attending school; however the children tended to not be re-enrolled in school. When part of the transfer payment was held until the start of the next school year, enrollment rates shot up. This is an example of using behavioral biases to advise policy and improve its effectiveness.

Making decision-making easier for people is another way to improve the effectiveness of social programs and policies for the poor by using behavioral economics. The World Bank describes it as a “cognitive tax.” When applying for food aid or entering a government sponsored credit payment for plumbing, the mental efforts needed to fill out the forms and cut through all the bureaucratic red tape can be overwhelming – especially to someone poor. Because of this “cognitive tax,” people tend not to engage in these programs that are in some cases quite literally handing out money. Improving participation rates in these programs that can be powerful when used can be as simple as streamlining the application processes. Reduce the “cognitive tax.”

As previously mentioned, the framing effect is one example of cognitive bias that can affect decision-making. The framing effect can be an important factor to consider when creating policy. As the World Bank used as an example, when naming a program or asking questions in the paperwork, using a program name like “Families in Action” would cause fewer stigmas and more participation as compared to “Needy Families.”

Using behavioral economics to inform social programs to reduce poverty is easy. It requires little extra cost or infrastructure. Attention to details, an understanding of decision-making, and trial and error can have a huge impact on a social program’s rate of return. It would be irrational to not use behavioral economic theory to help create better policies that can reduce poverty.

Martin Yim

Sources: The Atlantic, The American Economic Review, The Economist, World Bank

 

 

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About Author

Martin Yim

Martin is from Montgomery, New Jersey and is currently attending Boston University where he majors in Economics. He enjoys reading novels and current events, as well as staying active.

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