Psychology of Poverty

1. Psychology of Poverty Lecture 5, Economics 2030 Sendhil Mullainathan

2. Aside: Two Dominant Views of Poverty • Rational Choice view • Consistency, Willpower, Well-defined preferences,.. • Behavior: calculated adaptation to prevailing circumstances • This example illustrates an anomaly for this view • Pathology view • Psychological pathologies specific to the poor • Impatient, no planning, confused • Behaviors endemic to “culture of poverty”

3. Psychologically Richer Alternatives • Same behaviors; different interpretations • Rich are fallible; poor are equally fallible • Attention is just greater on fallibility of rich • Different challenges; same basic psychology • Will work through one model carefully • Different challenges; different psychology

4. Psychologically Richer Alternatives • Same behaviors; different interpretations • Rich are fallible; poor are equally fallible • Attention is just greater on fallibility of rich • Bertrand, Mullainathan and Shafir • Different challenges; same basic psychology • Will work through one model carefully • Different challenges; different psychology

5. Psychological Perspective • Large body of decision research (among the “comfortable”): • Biases in decision making • Limited willpower • Malleable preferences • Channel factors • Operating assumption: • Rich and poor have similar psychological make-ups • Same behaviors in fact (e.g. give in to defaults) • The consequences are differently interpreted

6. Example Psychology: Power of Context • Darley and Batson • Recruited seminary students to deliver practice sermon on the parable of Good Samaritan • After completing surveys, told to go to another building for the sermon • Half (“Rushed”) were led to believe they were running late

7. Psychology: Power of Context • On the way to give talk, all participants passed an ostensibly injured man slumped in a doorway, coughing and groaning. • Key DV: Would individual stop?

8. Psychology: Power of Context • Outcome: • No hurry 63% helped, • Medium hurry 45% • High hurry 10% • Notice: • These are priests…ironically giving a lecture on the good samaritan • Key insight: • Channel factors. Facilitate good behaviors

9. Implications of this insight • Revealed preference: • Outcomes do not reflect “deep” preferences • Situational factors can drive decisions • Design of institutions

10. Poor versus Rich • Why might common failings such as these lead the poor to be more affected than the rich? • Different institutions • Different problems/circumstances • Example application • Financial Services

11. Role of Institutions • Shape defaults • Provide implicit planning

12. Defaults

13. Institutions Shape default • Power of direct deposit • Default translates from cash in hand to cash in account • Must take active step to withdraw certain amount of money • Gives simple perspective on how direct deposit could have very large consequences for behavior • Suggests simple policy intervention

14. Unbanked • Why remain unbanked? • Channel factors? • The Federal Reserve Bank conducted a study in 2000 that asked un-banked families why they didn’t have a checking account. Among top reasons: Do not like dealing with banks. • What if…Unbanked due to: • Nuisances (sneers from teller, no babysitter…), • unfamiliarity, conscious violation of social norms • How do we reduce channel factors?

15. Bertrand, Mullainathan and Shafir • Phone survey of individuals that participated in the financial education workshops starting November 2002: • Entire population (900) sampled • 200 surveys completed • Attempt at experimental design over the summer of 2004: • “Bank representative” presence • Educational component of workshop • 3 experimental groups: • Only bank representative • Only financial education • Bank representative+financial education • 50 or so people in each group • 90 phone surveys completed • Access to bank account information for individuals in each group

17. Reasons for not Opening an Account • Very satisfied about program • 90 percent reported planning to open an account at time left the workshop • Why not opening then? • For up to a third: forgot, deadline expired, lost referral letter, etc…

19. Summary • Prior program proved of limited effectiveness (<50% take-up.) • Follow-up surveys: 90% intended to, but forgot, misplaced the relevant forms, etc… • 2-hour long workshop; If workshop participant interested in FA: • Referral letter to take to the bank, OR • Sign up on site if bank representative present at the workshop • Presence of a bank representative: significantly increased opening and keeping an account, and decreased check cashing, and borrowing from family. • Take-up: ~8 percentage points higher among those who voluntarily attended workshop. Take up: ~10 percentage points higher among those who attended workshop where a Shorebank representative was present. • (Can compare accounts opened at financial educ. workshop vs. tax prep. sites: No significant differences in closure rates, or in monthly usage patterns) • Cf., Retirement Savings; “Save More Tomorrow” (Benartzi & Thaler)

20. Deeper Issue • How do we encourage private sector to remove channel factors? • Key policy observation: • Channel factors are largely unobservable by regulator • Suggests outcome regulation rather than input regulation

21. Benefits of Banking • Perspective also suggests something else: • Why being unbanked can have big consequences • Cash on hand vs. in account • Help with planning • Access to other financial services that provide implicit planning and other automatic behavior

22. Psychologically Richer Alternatives • Same behaviors; different interpretations • Rich are fallible; poor are equally fallible • Attention is just greater on fallibility of rich • Different challenges; same basic psychology • Will work through one model carefully • Different challenges; different psychology

23. A Motivating Fact • The poor borrow at very high rates • Aleem: average interest rate 78% • MFIs in Mexico: 90%+ per year • Informal crop finance in our sample: 10-12% for 3 months • This is not just for coping with shocks • Many theories focus on supply side (e.g. monopoly, monitoring costs) • But what does consistent borrowing at these rates imply for the demand side?

24. Vegetable Vendors – Stark Example • Simple production function • Purchase fruit in the early morning • Sell through day • Basic working capital needs Karlan Mullainathan

25. Fruit Vendor

26. Vendors • Simple production function • Purchase fruit in the early morning • Sell through day • Basic working capital needs

27. Vendors

28. Vendors

29. Intertemporal substitution • Recall basic Euler equation for someone borrowing at rate R • Basic intuition: • People can always borrow less and finance out of their own consumption.

30. Implications of high interest rate • Discount future heavily (δ low) or • Future marginal utility large relative to today • Consumption growth large • u’(ct+1) low so ct+1 high • Note: this is stronger than saying that marginal product of capital is high. • Some existing studies suggest this as well. • Particularly sensible for transitory shocks (e.g. health). • But examples span even working capital uses (e.g. crop finance)

31. Vendors • Persistent borrowers • At very high rates • Stark implication: • One less cup of tea a day. • In 30 days will have doubled income. • Significant foregone income • Is this a rationale for consumer protection? • Tempted to debt?

32. Vendors Problem not unique • Payday Loans • Skiba Tobacman, 18% for loans lasting two weeks • People take many loans before defaulting • In essence paying the entire amount on their cycle before defaulting • Many other apparently myopic behaviors • Drug adherence

33. Understanding Poverty • To fit these facts current models must assume Poor are very myopic or Poor are quickly becoming non-poor • Since the latterappears counter-factual, we are forced to conclude the former

34. How to incorporate psychological insights? • Time inconsistency obviously helpful in resolving myopia tension • Standard model conceptualizes it as δ low • Present bias literature suggests more nuanced view • Individuals have inconsistent time preferences • Can be both myopic and farsighted • Two ways to incorporate time inconsistency • Constant time-inconsistency • Inconsistency problems which vary with income • Need simple framework to do both

35. Banerjee-Mullainathan • Question: Do time inconsistent preferences help explain phenomena of poverty? • Impose richer structure on temptation than just time inconsistency • Note: Intra-family conflict may generate similar results. Abstract from source of time inconsistency for now • Derive implications for: • Wealth dynamics (poverty traps) • Response to uncertainty • Savings behavior • Investment choices • Debt as a temptation • Money Lender Behavior

36. Nature of Self-Control • Time inconsistency often conveniently measured in money or total consumption • Tension is between how much now and how much later

37. Choosing Movies Read, Loewenstein & Kalyanaraman (1999) • Subjects given opportunity to choose a movie video from a set of 24 titles • Four Weddings and a Funeral • Schindler’s List • When choosing for today: 56% choose low-brow • When choosing for next Monday, 37% choose low-brow • When choosing for second Monday, 29% choose low-brow

38. Temptation goods • Suggests conflict not just in how much is consumed but what is consumed • Cigarette smoking • Unhealthy foods • Will assume “sophistication” in consumption • Not essential to our analysis

39. Assumptions • Two periods in most examples • Two types of index goods: x and z • x consumption: no time inconsistency • z consumption: only present selves like it • Instantaneous utility in each period u(x) + v(z) • Period 1’s decision utility: • Income each period yt and initial wealth w0 • Production function f(). Sometimes for simplicity will just assume rate of return R

40. Relation to Hyperbolic Model • Contrast two models • Equivalent in case where • For example same CRRA function

41. Re-interpretation of Hyperbolic Model • In other words the simple hyperbolic model on consumption assumes that temptations scale with regular consumption • This implies that relation between temptation and income (consumption level) is rather complicated • Consistent with present-bias broadly embodied in hyperbolic models • Goods provide certain amounts of now and later utils. Underlying psychology may still be about now versus later • Key is having a model that allows the explicit breakdown of goods according to “now”ness

42. Useful Lemma • Lemma: For any continuous and increasing z(x) and u(x) there exists a v(z) such that the optimal z consumption is defined by z(x) • Proof: u′(x)=v′(z(x)). DefineThen • Implication: Can think in terms of z(x) as primitive

43. Generalized Euler Equation • Traditional Euler Equation: • Generalized Euler Equation • Temptation tax: • Every dollar transferred into the future is “taxed” by temptations; future selves will waste some of it.

44. Poverty and Myopia • Two forms of “myopia”: δ and z’(w) • Original puzzle • Third explanation: myopia in the form of high z’(w). • Why is this different? • Because z’(w) can vary systematically with w • Individuals can control the value of z’(w) they face and hence the tax. • All our results come from this. • These considerations that traditional estimations of discount rates be biased

45. The shape of temptation • Two important cases: • z’(c) constant (Non Declining temptation) • Rich and poor face similar time inconsistency problems • Includes case of z’(c) = 0 • z’(c) declining • Rich face less time inconsistency problems

46. Implications of constant z’ • Useful applied insights • No different than applying standard models (e.g. hyperbolic)

47. Example applications • Demand for Commitment • SEED, ROSCAs • Purchase of Durables • Suppose durables provide fixed x utility • Individuals willingness to pay for durables will be • If discount factors on consumption or investment data assuming a traditional Euler equation, individuals will appear to over-demand durables relative to investments

48. Demand for durables • By over-investing enough in durables the current decision-maker locks in future x consumption (assuming that durables generate u consumption.

49. What is a Temptation? • Demand for commitment devices also tells us potentially what is a x-good? • People would only save up (in a commitment device or otherwise) to buy an x-good.