Irrationality and Economic Behavior

Irrationality and Heuristics: What can international development learn from behavioural economics?

by Carolynn Look, Institute for Advanced Development Studies

In a perfectly rational world, Ted the taxi driver works long hours on days with many customers and goes home early on bad days to save money on driving. On the other side of the world, Mexican farming couple Carlos and Verónica send their children to the new school built in the next town, because they know that education will lead to a job that will make up for the time not spent on the farm. Ted, Carlos and Verónica demonstrate what is a central tenet of classical economic theory : the belief in homo economicus, the rational economic man—a being that makes fully calculated decisions in a rational manner to achieve the best possible outcome for himself.

As elegant as this postulation is, since the 1950s, critics have been discovering that humans are not as rational as they appear to be in economic theoretical assumption. Political scientist and Nobel Prize winner Herbert Simon, for example, observed that we do not have unlimited brainpower, nor do we have the free time to scrutinise every one of our decisions. In short, he suggested that our problem-solving abilities are limited by “bounded rationality”. This leads us to come up with a set of basic rules of thumb that we apply when making decisions called heuristics, which are shaped by experiences and cultural bias. One example is the availability heuristic that Daniel Kahneman and Amos Tversky—the first psychologists to win a Nobel Prize for Economics in 2002—demonstrated in a famous 1973 experiment. Participants were given a list of names of 19 famous women and a list of names of 20 less famous men. The researchers argued that the fact that 80 percent of people thought the list of women’s names was longer showed that most people make decisions not based on calculated rationality, but on the ease with which examples come to mind (availability). The experiment has been replicated many times since and subsequent research has identified dozens more heuristics and biases that affect human decision making that are seen as inherently irrational.

There are many examples of seemingly irrational economic behaviour that is in part caused by heuristics and biases. We often lack self-control and overspend on things we don’t need. We are also occasionally altruistic, which conflicts with the standard economic assumption of human self-interest. And one of the most commonly observed behaviours is that people prefer to avoid losses than to acquire gains; they experience disappointment and panic following loss to a much greater extent than they feel happiness after making a profit.

These behavioural factors predictably affect how humans make decisions, and recognition of these determinants has thus become increasingly important in the work of economists, finance professionals and even computer scientists. So, can this knowledge also be applied to practical international development projects?

People who live in poverty are emotional, socially influenced human beings with tastes and preferences just like the rest of us, which might not always be the most ‘economically rational’. In addition, they have basic survival to worry about and a myriad of cultural customs that affect their response to aid.

Expecting rational outcomes, whilst failing to sufficiently take into account their own cultural biases, can lead economists and development workers astray and their projects to fail. This became quite apparent in the 1965 Chicken Improvement Project in Morocco organized by the United States Agency for International Development (USAID). Aid worker Thomas Dichter recounts his experience in his 2005 policy briefing Time to Stop Fooling Ourselves About Foreign Aid, recalling that Morocco, at the time, produced chickens that were scrawny and relatively expensive. Production experts working on the ground believed that they could improve both production and nutrition with better breeding. They brought in the Rhode Island Red chickens and the project went smoothly until the Moroccans had stopped buying the new chickens. Dichter recalls that the “Rhode Island Reds stewed for four hours tasted and looked like mush” and were therefore ill-suited to Moroccan cooking methods, which were based on scrawny tough birds. In retrospect, “rather than attribute this failure to problems inherent in the aid process, a field perspective might enable one to believe that if local taste and culture had been taken into account, the project could have worked,” he said.

A recent micro-finance project that took place in Ghana was testament to how accounting for social biases and seeming irrationality can yield more fruitful outcomes. Saving for the future may seem like a rational thing to do, yet many poor people—whose needs for basic survival are greater and who are less able to make long-term plans—do not, instead taking take out loans that trap them in debt. This was a central issue for a group of students from the School of Oriental and African Studies (SOAS), who worked in the southern village of Abuakwa, as Victoria von Waldersee, one of the students, explained:

“We were trying to change a mindset. Everyone’s reaction when we first asked whether they save money was, “I don’t have any money to save.” Telling people who live on far, far less than we do that they should save money was an incredibly difficult thing to do, but all we were trying to transmit was the idea that if you put aside a few cedhis a week, at the end of the month you’ll have a significant amount to spend. […] in Abuakwa, people spent as soon as they earned, seemingly for fear of losing the money in some way. That’s where the bank account we set up came in as a safe place to store money for later in life.”

Victoria spent her time making lists of household expenses and earnings over a certain period of time with a female tomato seller she was working with. It was so simple, yet such an important step towards financial literacy. These skills would be helpful in the future for repaying loans, or even showing the family that they don’t need a loan and are capable of saving money themselves. By making an effort to explain long-term benefits and incentivise smart economic behaviour the SOAS team was able to encourage more people to save for the future. These measures helped the Ghanaian villagers conquer the seeming irrationality that behavioural economists suggest is deeply rooted within all humans, both in advanced and developing countries.

As the hypothesis of homo economicus continues to be discredited in the real world and in research findings emerging from such fields as psychology and behavioural economics, economists, development workers, and other individuals involved in aid and general social and economic programming, would do well to remember that they too are laden with their own biases, assumptions and heuristics. Designing projects with local cultural and social contexts in mind are much more likely to lead to positive outcomes.

Do you know of any ways that development projects could compensate for seemingly irrational human nature? Leave your reply below.

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References:

• Dichter T. (2005). Time to Stop Fooling Ourselves about Foreign Aid, A Practitioner’s View. Foreign Policy Briefing, No 86, September 12, 2005

• Tversky, A., & Kahneman, D. (1973). Availability: A heuristic for judging frequency and probability. Cognitive Psychology, 5, 207-232.