Chapter 5. Behavioral development economics

Behavioral development economics applies theories and ideas from psychology and behavioral economics to the study of questions in development economics. We begin by examining a central puzzle in development economics: the existence of high rates of return without correspondingly rapid growth (the “Euler equation puzzle”). We discuss the extent to which present bias and loss aversion can help resolve this puzzle. We next consider various topics in development, including preventive health, savings, insurance, technology adoption, labor markets, and firms. We discuss particular behavioral theories that can help explain some key facts in each literature and describe the existing empirical evidence. Behavioral topics covered include non-standard preferences (present bias, loss aversion, and social preferences), nonstandard beliefs (naïveté and non-Bayesian learning) and non-standard decision-making (limited attention and memory, mental accounting, and default effects). We argue that firms in developing countries are more likely to deviate from profit maximization and that studying “behavioral firms” in developing countries is a promising new agenda for research. We also discuss a recent literature arguing that variation in social preferences is an important driver of development, may have deep historical roots, yet may also be responsive to policies. Finally, we describe the emerging literature on the psychology of poverty, which argues that living in poverty itself may causally affect cognitive function, decision-making, and productivity.