Behavioral Economics In Context Applications for Development, Inequality & Discrimination, Finance, and Environment By Anastasia C. Wilson An ECI Teaching Module on Social and Environmental Issues in Economics Global Development Policy Center Boston University 53 Bay State Road Boston, MA 02155 bu.edu/gdp Economics in Context Initiative, Global Development Policy Center, Boston University, 2020. Permission is hereby granted for instructors to copy this module for instructional purposes. Suggested citation: Wilson, Anastasia C. (2020) “Behavioral Economics In Context: Applications for Development, Inequality & Discrimination, Finance, and Environment.” An ECI Teaching Module on Social and Economic Issues, Economics in Context Initiative, Global Development Policy Center, Boston University, 2020. Students may also download the module directly from: http://www.bu.edu/eci/education-materials/teaching-modules/ Comments and feedback from course use are welcomed: Economics in Context Initiative Global Development Policy Center Boston University 53 Bay State Road Boston, MA 02215 http://www.bu.edu/eci/ Email: [email protected] NOTE – terms denoted in bold face are defined in the KEY TERMS AND CONCEPTS section at the end of the module. BEHAVIORAL ECONOMICS IN CONTEXT TABLE OF CONTENTS 1. INTRODUCTION ........................................................................................................ 4 1.1 The History and Development of Behavioral Economics .......................................................... 5 1.2 Behavioral Economics Toolkit: Fundamental Concepts and Principles .............................. 5 1.2.1 Prospect Theory: Evaluating Risk and Time ............................................................................. 5 1.2.2 Self-interest vs. Fairness .................................................................................................................. 6 1.2.3 Heuristics, Anchoring, and Framing ............................................................................................ 8 1.3 Rationality and Behavior in Context .................................................................................................. 8 2. PSYCHOLOGY AND ECONOMIC DEVELOPMENT: CONTEXT, INSIGHTS, AND POLICY EXAMPLES .............................................................................................. 9 2.1 How Can Behavioral Economics Inform Development? ......................................................... 10 2.2 Economic Context Matters: How Poverty Impacts Decision-Making ............................... 11 2.2.1 Scarcity Creates Cognitive Scarcity .......................................................................................... 11 2.3 Cultural and Social Context Matters: Cultural Norms, Biases, and Mental Models ...... 13 3. UNDERSTANDING THE PSYCHOLOGY OF INEQUALITY ............................. 15 3.1 Our Perceptions of Inequality ........................................................................................................... 15 3.1.1 Cognitive Dissonance, Confirmation Bias, and Inequality Aversion .............................. 17 3.2 Evidence on the Persistence of Inequality and Bias ................................................................. 19 3.2.1 Testing Implicit Bias ...................................................................................................................... 19 3.3 How Inequality Shapes Us .................................................................................................................. 20 3.4 Conditional Altruism, Reciprocity, and Fairness: Experimental Evidence to Inform Policy .................................................................................................................................................................. 21 3.4 Critiques and Questions ...................................................................................................................... 23 4. BEHAVIORAL FINANCE, HISTORICAL PERSPECTIVES, AND THE FINANCIAL CRISIS .................................................................................................. 23 4.1 Behavioral Finance in Historical Perspective ............................................................................. 24 4.2 Behavioral Insights for the 2007-2008 Financial Crisis ......................................................... 27 4.3 Building a Better Financial System? ............................................................................................... 28 4.3.1 Financial Transactions Tax ............................................................................................................... 28 4.3.2 Consumer Finance and Behavioral Insights ............................................................................... 30 4.4 Behavioral Economics and the Future of Finance ..................................................................... 30 BEHAVIORAL ECONOMICS IN CONTEXT 5. BEHAVIORAL INSIGHTS FOR ENVIRONMENTAL AND CLIMATE ECONOMICS................................................................................................................... 30 5.1 Applying Prospect Theory to Understanding Climate Change: Hyperbolic Discounting and Reference Points ................................................................................................................................... 33 5.1.1 Hyperbolic Discounting ....................................................................................................................... 33 5.1.2 Reference Points ..................................................................................................................................... 33 5.2 Behavioral Environmental Policy Tools: Framing, Defaults, Norms, and Commitment Devices............................................................................................................................................................... 34 5.2.1 Framing and Default Options ........................................................................................................... 34 5.2.2 Social Norms and Comparisons ....................................................................................................... 35 5.2.3 Commitment Devices and Nudges .................................................................................................. 36 5.3 Concluding Ideas: Are Nudges and Behavioral Interventions Enough? ........................... 37 6. CONCLUSION TO BEHAVIORAL ECONOMICS AND ITS POLICY APPLICATIONS ............................................................................................................. 38 KEY TERMS AND CONCEPTS .................................................................................... 39 REFERENCES ................................................................................................................. 42 ADDITIONAL RESOURCES ........................................................................................ 43 DISCUSSION QUESTIONS ...................................................................................... 44 BEHAVIORAL ECONOMICS IN CONTEXT 1. INTRODUCTION The field of behavioral economics applies psychological insights to understanding economic decision-making. Many of these insights go beyond mainstream economic models based on rationality to show how human psychological tendencies influence economic life, and may not always lead to perfectly rational choices. Further, social psychology shows how collective group dynamics and social contexts influence economic decisions. These insights have applications not only for individuals, but also for effective policy design and implementation. This module explores the applications of behavioral economics to four policy issues: 1. Economic Development: For developing countries, understanding human psychology is crucial for effective policy design. Behavioral economics can help policy-makers understand the cultural and psychological contexts of issues such as poverty, use of public goods, implementation of new programs, and so on. Policies that are mindful of psychological and social contexts can be more effective both in terms of successful adoption and in overall costs. This module will look at several cases where psychological insights can produce cost-effective policies. 2. Inequality and Discrimination by Race and Gender: Economic inequality is an issue of increasing concern to economists. Inequality exists both on the macroeconomic scale, in terms of broad income and wealth inequality, as well as in terms of race, ethnicity, gender, and other categories. Behavioral economics allows economists to better understand these forms of inequality based on how they relate to social norms, implicit bias, and psychological predispositions to inequality. Understanding how these inequalities manifest via psychology can provide important policy insights for ameliorating these social issues. 3. Finance and Economic Crises: Behavioral economics has long been relevant to the world of finance. Even from the time of John Maynard Keynes, investor and consumer psychology has been key to understanding financial markets and crises. Keynes and other pioneering economists like Hyman Minsky were early contributors to what would later become the field of behavioral finance, showing the roles of investor psychology and uncertainty in contributing to the boom and bust cycles of a capitalist economy. We will review these historical insights, and overview the modern field of behavioral finance and its applications to understanding