Behavioral Development Economics: Addressing the Euler Equation Puzzle and Psychological Dimensions of Poverty

This lecture introduces behavioral development economics (BDE), tracing its historical roots and distinguishing it from earlier views of development. Initially, development theory posited fundamental differences between pre-modern and modern societies, suggesting that standard economic models might not apply to the poor. However, development economics emerged as a critique, asserting that poor individuals are rational actors making choices under constraints, famously summarized as 'poor but efficient.' The advent of behavioral economics, with its insights into systematic deviations from standard rational models, led to the integration of psychologically realistic views of human behavior into development studies, recognizing universal behavioral biases applicable to both rich and poor.

The lecture then delves into common critiques and caveats of BDE. It emphasizes that BDE aims to augment and improve, rather than replace, existing neoclassical models, acknowledging that prices and incentives remain crucial. It also highlights that BDE does not deny the importance of institutions, and in fact, suggests an increased role for them in guiding potentially biased choices. Crucially, BDE avoids blaming the poor for their circumstances, attributing suboptimal choices to universal psychological factors, preferences that are not blameworthy, or the direct 'treatment effects' of poverty itself. The concept of 'libertarian paternalism' is introduced as a policy approach that helps individuals with behavioral biases without infringing on their freedom of choice.

A significant portion of the lecture is dedicated to the 'Euler equation puzzle,' which arises from the observation of high returns to capital in many developing contexts. The standard Euler equation, linking consumption today to consumption tomorrow via returns to capital and discount rates, implies unrealistically high consumption growth rates (e.g., 20-44% annually) when combined with observed high returns and standard discount factors. The lecture explores various potential explanations for this puzzle, such as borrowing constraints, kin taxes, non-concave production functions, and stochastic income with risk aversion, but finds them quantitatively or conceptually insufficient to fully resolve the discrepancy. For instance, simply assuming extreme impatience (low discount factor) leads to implausible predictions about long-term investment.

The proposed resolution to the Euler equation puzzle, and a core contribution of behavioral economics, is the concept of present bias or quasi-hyperbolic discounting. This framework posits that individuals have a higher discount rate for immediate future periods (today vs. tomorrow) compared to more distant future periods (10 years vs. 11 years). This separation of short-term (beta) and long-term (delta) discount factors allows for both short-run impatience and long-run patience, providing a more consistent explanation for observed behaviors like low savings despite high returns to capital, without leading to the implausible long-term implications of a uniformly high discount rate. This approach underscores the need for systematic, disciplined modeling that can match multiple empirical facts, rather than isolated parameter adjustments.

"Most of what I'm going to tell you is is based on a handbook chapter on behavioral development economics with Michael Kremer and Gautam Rao."

"Development economics in in in part at least emerged as a critical response to this view. It's sort of saying like no, people are poor people are people like you and I that make choices, they make productive decisions."

"And this is sort of this famous expression from Schultz in 1964 that's sort of saying is people are poor but they're making choices, they're making rational choices and we can apply the entire toolbox of development or of economics of microeconomics uh etc. to sort of the applications of studying poverty."

"Just like for the rich there's systematic deviations from standard models in preferences, beliefs and decision making."

"Behavioral development economics is also very much not denying the importance of institutions for development. In fact, you might say institutions are even more important."

"Nobody's trying to blame the poor for their poverty, for like sort of perhaps making mistakes or other sort of choices that might not might be suboptimal in some ways."

"The best of um uh behavioral economics tends to have what's called libertarian paternalism. It's trying to essentially design policies, for example, defaults or other types of choices where you help people who have behavioral biases while not sort of interfering with other freedom of choice overall."

"So essentially what this sort of tells us, and this is I think a key point about behavioral economics, you can't just sort of like fix one parameter and say, look here's some behavior that we can fix in isolation and say, okay, now we're sort of done."

"Alternative hypothesis that people have studied quite a bit is present bias or present focus as people have called called it. Which essentially is the idea that you can separate the discount rate between today and tomorrow or today and next year from the long-run discount rate in the future."