Chapter 16
Behavioural Economics
Main stream Economists assumed that humans make rational and optimal and decisions. In his book, the economic Approach to Human Behaviour (1976) Gary S Becker, Nobel Economist, outlined a number of ideas known as pillars of so called ‘Rational Choice Theory’. The theory assumes that human actors have stable preferences and engage in maximizing behavior. Becker applied rational choice theory to domains ranging from crime to marriage.
Amos Tersky and Daniel Kahneman published a number of papers that appeared to undermine ideas about human nature held by main stream economists. They are perhaps best known for the development of prospect theory (1979) which shows that decisions are not always optimal. Our willingness to take risks is influenced by the way in which choices are framed, i.e., it is context dependent. Their publication prospect theory – An Analysis of risk under uncertainty is one of the foundations of Behavioural Economics. Have a look at the following decision problems. If you are offered a gamble on the toss of a coin.
B). A certain loss of Rs. 100
D). 90% chance of losing Rs. 1000
The choices are framed differently and the responses are different. When faced with the first type of decision, a greater proportion of people will opt for the riskless alternative A, while for the second problem, people are more likely to choose the riskier D. This happens Because the price of losing Rs. 900 in more than 90% chance of the pain of losing Rs. 1000. In the first case (1) losses loom large than gains and people are loss averse. In the second case (2) by comparing possible losses, one certain, and other, merely possible, causes risk taking. These two insights are the essence of Prospect Theory.
Khneman discusses the psychological under pinning of economic life in his book, Thinking Fast and Slow. The importance of psychologically informed economics was, later reflected in the concept “bounded rationality”, a term associated with Herbert Simon’s work of the 1950decisions are not always optimal. There are restrictions to human information processing, due to limits of knowledge (information) and computational capacities. Let us illustrate irrationality, in a real economic situations. In an efficient market, when rationality is common knowledge, there is no trading but in actual markets there are millions of shares traded daily. Secondly Rational people act selfishly and do not cooperate. Economists assume that self interest is the primary motive for rational people. The free rider problems widely, discussed in economics predicted to occur because individuals cannot be expected to contribute to public good, unless their private welfare is thus improved. Actually, people act selflessly and systematically cooperate.
Empirical evidence from psychology and Behavioral Economics, shows that consumers choices and actions often deviate systematically from neo-classical assumptions of Rationality and there are certain fundamental and persistent biases in human decision making that regularly produce behavior that these assumptions cannot account for. Many of the biases stem from: rules of thumb, heuristics and mental shortcuts that alleviate the need for more effortful information processing, thereby hastening the speed of decision making.
Among the most powerful and pervasive biases to influence consumers bahaviour include:
The statuesque biases, loss and risk aversion, sunk cost effects, temporal and spatial discounting and availability by us in parallel psychological phenomenal such as normative social influence, incentive and extrinsic rewards and trust. A large body of research shows that even when cost-benefit calculations would suggest more materially advantageous choices people persists in displaying seeming irrational behavior (type 1: household energy use – replying behavioral economics www.sciencedirect.com) (Type 2: Frontiers Energy use – Why consumers)
Thaler is considered as the founder of Behavioral Economics. Thaler is awarded the Noble prize in Economics, 2017 for his Contributions to Behavioral Economics. Thalers vision for incorporating insights from Psychology into Economics was laid out in his early book Quasi-Rational Economics in 1991. In his books like misbehaving – the making of Behavioral Economics, Nudge – improving decisions and other books and many articles he continued to analyze how Economic decisions are influenced by psychological factors. In his book misbehavior (2015) he provides a history and development of Behavioral Economics. His bestselling book, is Nudge, (Co-authored with Sunstern).
A Nudge is any factor that significantly alters law behavior of Humans (homo-sapiens) even though it would be ignored by Econs (homo-economicus) Econs respond to incentives, humans respond to incentives too but there also influenced by Nudges.
Some of the contributions of Thaler that deviates from rationality in human behavior are discussed here. A first contribution of Thaler is his pioneering work in how Endowment Effect (1980) deviates from ideally rational behavior. He coined the term Endowment effect for the tendency of individuals to value items more just because they own them. A good often appears to be more highly valued when it is part of an individuals endowment compared to when it is not. People place a higher value on their own possessions. In a famous experiment he and two coauthors, distributed coffee mugs to half of the students in a class room, and then opened a market for mugs. Students randomly given a mug regarded it as twice valuable as did the students who were not given a mug.
Neo-Classical Theory can hardly explained a large difference between Willingness To Pay (WTP) and Willingness To Accept (WTA) Thaler found an explanation in prospect theory. He noted that if giving up an object is perceived as a loss, then loss averse individual will behave as if the objects they own or more highly valued than similar objects they do not own. This effect, which Thaler named Endowment Effect can explain the large difference between WTP and WTA.
Another contribution of Thaler relates to importance of fairness. He showed that people will penalize unfair behavior even if they do not benefit from doing so. This has important economic implications. It explains for example, why an umbrella store may choose to not to raise prices during a rain strom. People have firm standards of fairnesses. Since most consumers cannot know what goods are actually work, they determine value based on fairness. Perhaps $ 5 for an umbrella is fair, - but if the price is raised from $ 1 during a downpour, the familiar feeling of that being gouged might discourage sales. While an umbrella seller could be right in raising prices during the periods of high demand – thus efficiently allocating umbrellas to people who are willing to pay the most – it also goes against of a person’s concept of what they believe to be fair.
Another example of irrational behaviors is the Cab-driver’s behavior. Thaler and others, in their papers observed that Cab drivers work few hours on rainy days. They speculated that cab drivers have a particular level of income they target and each day. When they hit the target, the cabbies go off duty. The increased demand for cabs in bad weather increases the number of fares per hour. So, cab drivers reach their target sooner and go off duty. Each hour of work is more lucrative. If the cab drivers are rational they should work more hours.
Thaler’s studies show that Americans save too little. People display time inconsistent behavior weighing current consumption especially heavily. They are irrational. Economic theory generally assume that people solve important problems as economists would. The life cycle theory of savings is a good example. Households are assumed to want to smooth consumption over the life-cycle and are expected to solve the relevant optimization problems in each period the four deciding how much to consume and how much to save. Actual household behavior might differ from their optimization plan for either of two reasons. First, the problem is a hard one and so households might fail to compute the correct saving rate. Second, even if the current savings rate were known, households might lack self-control to delay current consumption in favour of future consumptions. Anchors serve as nudges. We can influence the figure you will choose in a particular situation by ever-so-subtly suggesting a starting point for your thought process. When charities ask you for a donation, they typically offer you a range of options such as Rs. 100, Rs. 1000, Rs. 5000 or other. The options influence the amount of money people decide to donate. People will give more if the options are the ones given above rather than the options are Rc. 50, Rs. 75, Rs. 100, Rs. 150. The more you ask for, the more you tend to get.
Take another example. A cafeteria manager can influence the eating habits of the people by choosing a particular arrangement of food options. He can nudge. The manager should take the opportunity to nudge people toward food that is better for them.
For a summary of all Thalers contributions, to Behavioral Economics, download the following article – Richard Thaler’s contributions – Advanced Economic Sciences : 2017. (Integrating Economics with Psychology)
Chapter 17
Economic Growth and Development
(Solow, Lewis, Kuznets, Schultz, Becker, Myrdal, Angus Deaton)
The genesis of Growth theory in the last Century can be traced to. Harrod and Domar Model.s As theyare similar we discuss. Harrod- model. Explanations of Harrod model are many and the one given by A.K.Sen, in his Introduction to Growth Economics, is brief and excellent. As such, we follow Sen’s explanation of Harrod model.
It can be shown that the following relation holds between the actual and the expected growth rate.
The actual growth rate gt, is equal to expected growth rate ĝt if and only if the expected growth rate, is equal to the warranted rate of growth, s/C where ‘s’ is the saving rate and ‘C’ is capital-output ratio otherwise there will be Harrod’s instability problem. If the investors expect more than the warranted rate of growth, s/C then the actual growth rate of demand will exceed expected growth rate.
Suppose, the saving rate is a 20% and the Capital-Output ratio C is 4, then the warranted growth rate is 5%. Suppose the current output level is 95, so that a 5% increase will, mean a movement to 100(approximately). If the investors in fact expect an output of 100, they will invest 20 units,(5.4) to create an additional capacity for an additional units of demand. The investment of 20 units will generate a demand level of 100,so that expectations will be realized. Suppose, the investors expect more, say 102 units of demand they have to create capacity to meet additional demand of 7 units (102-95). They invest 28 units (7.4) and through the multiplier investment of 28 units will generate a demand level of 28. 5=140 Investors will feel that they have expected too little demand. Similarly if the investors expect less, say 98, then they will invest 12units(3 . 4) and it will generate demand of only 60 units. So they feel that their expectations are very high.
Harrod employs another growth rate, the ‘Natural’ rate of growth. Harrod’s Natural rate of growth is the maximum sustainable rate of growth in the long run given by the rate of growth of the Labor force, ‘n’ and the rate of labor-saving Technical progress, ‘m’. if the warranted rate of growth given by s/c is equal to the natural rate, there is no problem. But if the warranted rate ‘Gw’ is greater than the Natural rate, Gn, then actual reaches a ceiling limit of full-employment, which may result in departures from equilibrium. On the other hand Gw<Gn then a, growing portion of un-employment will emerge.
Thus according to Harrod an economy achieves a steady growth at a constant rate only when the saving rate is equal to the product of the Capital-Output ratio and rate of growth of the (effective) Labor force.
Dissatisfied with Harrod’s crucial assumptions and its main conclusions, Solow published his classic article” A contribution to the Theory of Economic Growth” in 1956. His article marks the beginning of the Neo-Classical Model of Economic Growth”; the gist of the article is presented below.
Solow’s growth model is presented in the following fundamental Equation.
r1 + n.r = sF(r,1) or r1 = sF(r,1) – n.r
Where ‘r1’ is the rate of change in capital-labor ratio.
The function F(r,1) gives the total product as varying amounts of capital are employed with one unit of labor. Alternatively, it gives output per worker as a function of capital per worker.
Consider the right hand side of the equation. we know sF(r,1) is simply saving per worker and since in this model, saving automatically become investment, it can be interpreted as the flow of investment per worker. The second term in equation, n.r is the amount of investment that would be required to keep the capital – labor ratio ‘r’ constant, given that the labor force is growing at a constant proportional rate of n. Thus the rate of change of the capital – labor ratio, (r|) is determined by the difference between the amount of saving (and investment) per worker and the amount required to keep the capital – labor ratio constant as the labor force grows.
When the two are equal, r will be constant at the equilibrium value, re (r1= 0).
Using the above equilibrium point, there is a simple mechanism to make the equilibrium stable. Suppose for example; there is a departure from equilibrium value, re. If savings fall short of the required investment nr, then Capital labor ratio decreases toward the equilibrium value. If savings exceed the required investment, then the Capital-labor ratio will increase toward the equilibrium value.
The following conclusions are drawn from Solow’s model.
Solow and other Neo-Classical writers argued that relative shares of Labor and Capital depend on the ratio of marginal and average productivities of the Factors. The share of a Factor of Production is equal to the elasticity of production with regard to that factor. Under the assumption of constant returns to scale and competitive markets, Solow suggested that the rate of growth of output is equal to the rate of growth of labor multiplied by its share in output plus rate of growth of capital multiplied by its share in output plus the residual. This Solow’s residual is termed multifactor productivity growth. It is observed that in U.S. the output-capital ratio is relatively constant for a long period. This implies a positive Solow residual, equal roughly to the labor share times the rate of growth of labor productivity. The rate of change of multifactor productivity of Solow residual is estimated to be 1.7 in U.S. during 1950 to 1975, accounting for approximately half of the growth of the private economy of U.S. over the whole period. The source of the residual is not known.
Modern Growth theory is devoted to analyzing properties of Steady-states in industrial economies. However, Growth Theories provide useful insights to growth problems of developing Countries also. Solow’s endogenous model of growth has relevance for developing countries and it is discussed below.
Solow’s Endogenous model of Growth
In the Solow’s exogenous model discussed earlier, the relative rate of Population growth in treated as constant, n. Later, Solow relaxes this assumption and make Population an endogenous variable. This model is discussed in his book Growth Theory (2000). Suppose, for example, for very low levels of income per-capita the (real wage) Population tends to decrease; for the next stage higher levels of income, it begins to increase and that for still higher levels of income, the rate of Population growth levels off and starts to decline. The rate of growth of population depends on the level of per-capita income. Since per-Capita income is given by Y/L = F(r.1), the upshot is that the rate of growth of the labor force becomes n = n(r). The earlier Fundamental Eq. now becomes:
r1 = s F(r,1) – n(r).r
Thus, the rate of change capital/labor is constant if per capita savings are equal to the investment requirement. With Population growth nr(r), the investment requirement rises slowly, then sharply and eventually flattens out. The per-capita savings remains the same.
The investment requirement may equal the savings at low and high points r1 and r2. Point r1 is the Poverty trap point, with high Population growth and low income. The equilibrium point r1 is stable. If the initial Capital-labor ratio is less than r2 the system will move back towards r1. Point r2 is unstable. If the initial capital-labor ratio can be raised substantially by investing in a big way, so as to make it go beyond the critical level r2, then economy experiences a self-sustaining growth with increased income. The economy can avoid the Poverty trap by increasing savings and reducing the rate of Population growth.
W.A.Lewis
W.A.Lewis classic article, “Economic Development with Unlimited Supply of Labor” published in 1954, gave rise to enormous Research on the contemporary problems of large areas of the earth (of developing countries). As such the salient points in that article are presented here.
Lewis, like Classical writers, assumed the existence of disguised labor in agriculture in developing countries. In the Lewis model there are two sectors-the agricultural sector and the manufacturing sector. The two sectors may as well be described as ‘subsistence sector’ and the ‘capitalist sector’. The Capitalist sector is that part of the economy which uses reproducible capital and pays for the use thereof. The remaining part of the economy is the subsistence sector.
The Capitalist sector can expand indefinitely at a constant wage rate for un-skilled labor, drawn from the Agricultural sector. The actual wage rate will be determined by earnings in the subsistence sector, which is equal to average product and not marginal product. It is because by convention everyone in a household received an equal share of what is produced. Capitalist will have to pay some margin-perhaps 30% above average of a subsistence pay because the surplus workers in agriculture need some incentive to move to urban areas for being employed in the manufacturing sector. Supply of labor is perfectly elastic to the manufacturing sector at the current wage so determined at the institutional wage in agriculture.
In the Capitalist sector, the marginal product curve will be concave (from origin) and will be decreasing. In the Capitalistic labor will be employed up to point where its marginal product equals wage. The Capitalist will get Producer’s surplus. The surplus is reinvested by the capitalist which raises the schedule of marginal productivity of labor. And the process continues as long as there is surplus of labor. The Lewis model, in effect says that unlimited supplies of labor are available at a constant real wage and if any part of profits is reinvested in productive capacity, profits will grow continuously relative to national income and capital formation will also grow relatively to national income.
The central fact of economic development is rapid capital accumulation. Lewis model popularized the concept of Dualism in which a small industrial sector grows to absorb greater amounts of agricultural surplus labor, without adversely affecting agricultural production.
And, extending the migration mechanism suggested in Lewis model, Michael Todaro developed two-sector migration model. In the Lewis schema, people migrate from rural to urban areas in response to assured urban employment, and with out a real wage differential. In Todaro model, however, the parameters become variables. According to Todaro, an individual’s decision to migrate is a function of income gain of an urban job weighted by likelihood of finding such job. Lewis & Todaro models of Dualism are more realistic than the earlier Sociological Dualism, proposed by Dr. Boeke. According to Dr. Boeke; “Social Dualism is the clashing of an imported social system with an indigenous social system of another style”. The imported social system of high Capitalism (from the West), clashes with the existing pre-Capitalist system (in the East). According to Boeke, Dualism arises from a clash between East and West, specially between the Cultural traits of their societies.
Kuznets
Kuznets is well known for his significant contributions to Economic Growth. A Bibliography of his works is given in his latest book (published posthumously), Economic Development, the Family and Income Distribution.
As the books of Kuznets are available and accessible to Indian students and non-technical and understandable there is no point in giving all the findings of Kuznets researches. We present one important empirical finding by Kuznets.
Based on Kuznets empirical findings and conclusions a tentative hypothesis is formulated which states that income inequality first rises and then falls with development. A plot of inequality (on vertical axis) against a measure of development such as per-capita income (on horizontal axis) would then look like an inverted ‘U’ (looks like ‘∩’.
Gunnar Myrdal
Gunnar Myrdal’s methodology is characterized by an interdisciplinary approach, to social problems. In analyzing social problems he takes into consideration not only ‘pure economic factors but also the social, demographic and institutional aspects’, Further, he states his value premises explicitly.
Myrda