Are the poor risk averse? Just ask Banerjee and Duflo

Nobel laureates Abhijit Banerjee, Esther Duflo and Michael Kremer (Image: Twitter/@NobelPrize)

Avinash M Tripathi

One of my childhood memories relates to visiting a temple town.

As we were moving towards the central building in a large group, we were approached by a hawker selling kesar (saffron). The quality was excellent; the price reasonable (Rs 120 per gram if I remember correctly).

After some members of the group had purchased it, the hawker vanished. As we moved a few hundred yards, we were approached by another hawker selling the same commodity. Except this time the offer price was lower at Rs 100 per gram. Sure enough, some members of the group repeated the purchase; others bought it for the first time.

As we kept moving, this pattern kept repeating. Curiously, we were approached by different hawkers and the offer price kept declining monotonically by Rs 20 each time. By the time we had reached the temple, the price had dropped to Rs 20 per gram.

While it may not be obvious to the reader, this is a textbook example of a business tactic known as price discrimination. For example, book publishers adopt this strategy when they sell the multiple editions of the same book --hardbound, paperback, etc -- at different prices. Barely literate hawkers were using this sophisticated strategy without ever attending a business college!

Once you ponder over it, a bigger question emerges: If poor, semi-literate hawkers can come up with such sophisticated business strategies on their own, why do they remain poor in the first place?  To put it differently, despite having the acumen, why do the poor start so many businesses that fail to scale up?

In a nutshell, it is for asking and answering questions like this that Abhijit Banerjee, Esther Duflo and Michael Kremer have been awarded the Sveriges Riksbank Prize in Memory of Alfred Nobel -- popularly known as Economics Nobel -- this year.

The press release notes: This year’s Laureates have introduced a new approach to obtaining reliable answers about the best ways to fight global poverty. In brief, it involves dividing this issue into smaller, more manageable, questions – for example, the most effective interventions for improving educational outcome or child health. They have shown that these smaller, more precise, questions are often best answered via carefully designed experiments among the people who are most affected.

The “new approach to obtaining reliable answers” referred to in the release is Randomized Control Trial (RCT). It is a method for measuring the effectiveness of some policy intervention by randomly allocating the intervention among participants and comparing the outcome for treatment and the control group. The selling point of RCTs is they could prise out causal relationships from data in a more robust manner. However, it is possible to argue that there is more to RCTs in the Banerjee and Duflo oeuvre. Read comprehensively, their work could be worldview changing.

For example, one common misconception is that the poor are indolent, risk averse and lacking in enterprise. In casual conversations, risk taker is often used as a synonym for the successful businessman. In the neo-classical formulation, profit is the reward for risk bearing. Banerjee and his co-authors turn this worldview on its head. They argue that the poor are always facing enormous amount of risk that most of us -- secure in steady salaries, pensions and health insurance contracts -- can barely imagine.

That is why they describe the poor as barefoot hedge fund managers and reluctant entrepreneurs. When your income is less than one dollar per day, you're always one disaster away from losing your employment, health and even life. This persistent source of uncertainty shapes the attitudes and actions of the poor in fundamental ways. The implications of this for saving, investment and consumption decisions are studied by Banerjee and his co-researchers.

Some of their papers combine theory and data in a beautiful way. In one such paper, Banerjee and Duflo estimate the importance of reputation in the Indian software industry. Software products are complex to specify in advance and Indian legal system is notoriously slow and inefficient. The economic theory suggests that in such a situation, the reputation of the firm should have a strong bearing on the form of the contract signed between the parties. Banerjee and Duflo find that such effects not only exist but are in fact quite substantial.

Yet another paper of Banerjee’s that was far ahead of its time analysed the ‘economics of rumours’. ‘Rumour’ is defined as a kind of information where recipient is not sure how much to trust it. Banerjee investigates the implication of such information flows for decision making. While the original paper is about investment decisions, the analysis remains extremely relevant in the age of social media and fake news.

Given their body of work, the Nobel prize for the trio was a matter of time. However, few would have guessed that it would be awarded at such a young age. Before this award, youngest Nobel recipients in Economics were Kenneth Arrow and Paul Krugman (51 and 56 years respectively at the time of the award). After this week’s award, the youngest economics Nobel winners are Esther Duflo (46 years) and Michael Kremer (55 years). Given their young age, one can be sure that the Laureates are not going to rest on the laurels alone and we can expect plenty of interesting papers in coming years as well.

Avinash M Tripathi is Associate Research Fellow (Economics) at Takshashila Institution. Views are personal.