Sunday, December 6, 2009

Karelis explains the economics of poverty

Explaining the persistence of poverty has been one of the most enduring of socio-economic debates. Despite all this, there have been no satisfactory enough single explanation that captures all the reasons behind poverty and its persistence. And I am inclined towards the belief that complex challenges like poverty cannot be explained in a grand and all-encompassing narrative.

Conservatives and free-marketeers advocate the importance of getting incentives right in addressing the problem of poverty. They claim that once the required framework that provides everyone with equality of opportunities is put in place it becomes easy to eradicate poverty. These microeconomic foundations have been used to favor policies that emphasize good governance, institutions, rule of law, access to basic health care and education, and so on. They have also been invoked to oppose direct welfare measures that go beyond the most minimum of social safety nets and even multi-lateral aid. It is claimed that such support measures fail to achieve their poverty alleviation objectives and only end up distoring incentives by discouraging effort and promoting inefficiency and corruption.

Such simplifying narratives of a complex issue like poverty is audacious at best and plain ignorant at worst. Such explanations fail to appreciate the true complexity of poverty and deprivation and fails to acknowledge the importance of specific contextual factors (local community instiutions, weather, geography, politics etc) that keep people poor. Its underpinning rational economic man also ignores the bounded rationality of human beings that behavioural economists have exposed under a number of different circumstances with poor people. It is from this framework that I find Charles Karelis's work interesting and a welcome addition to the growing literature that helps us better understand the context in which poverty flourishes and the reasons why it is so impervious to change.

I have blogged earlier about Karelis's alternative explanation for the persistence of poverty, in which he claims that poverty introduces a diminishing marginal utility to putting in effort. He argues that classical microeconomic explanations of consumption and satisfaction that satisfactorily explains the economics of the well-off cannot explain that of the poor.

Karelis makes the distinction between pleasure goods and good that are relievers, and some goods can act as both, and claims that while there is diminishing marginal utility in pleasure goods, relievers have increasing marginal utility. As Karelis writes, "paying the first bill in a stack of overdue bills does little to relieve a guilty conscience".

Mike Konczal has this nice summary of Karelis' arguement

"Picture you are in a room with 10 people. Each of them has a slice of cake... You’d be willing to pay a $1 for the first slice of cake, but you’d only be will to pay 90 cents for the second slice. You’d only be willing to pay 10 cents for the 9th slice, and a penny for the 10th slice...

Now picture you are in a room with 10 people screaming. You hate it when people scream, and you can pay a person to get them to stop screaming... Getting one person to stop screaming would make very little difference in how much you dislike being in the room. Modern psychology tells us you might not even notice it. You’d probably only pay a penny to get that first guy to stop screaming. However getting the second guy to stop screaming might be worth 10 cents. And the last guy, the difference between some screaming and no screaming, might be worth the full dollar to you. The more quiet it got, the more a marginal difference in how quiet it is would be worth to you. There’s increasing returns to this good; the 10th guy not screaming is worth more than the first guy not screaming, which is the exact opposite dynamic of the 10th cake being less delicious than the first...

Let’s say that instead of money, you are given 20 tokens to be used over 4 days, and each token gets you one slice of cake in room #1, and one person to stop screaming in room #2. In the cake room, the optimal decision is to consumption smooth – eat five slices of cake each day, so you use the tokens {5,5,5,5}. In the screaming room, all the enjoyment is not in getting a room with half screaming but in getting a quiet room, and instead of consumption smoothing the optimal choice is to binge – pay 10 people to stop screaming the first two days, and deal with a loud room the last two days – {10,10,0,0}...

And most interesting, instead of tokens, let’s say you could work an hour for 1 token or take 65 cents in leisure over a 5 hour day. In the cake room, you’d probably work 3 hours, and relax 2 hours, as around that time you’d have the marginal return from cake equally the marginal return from relaxing. In the screaming room, you probably wouldn’t work at all – it’s impossible enough to make enough to stop the screaming to the point where it is worthwhile to try. Hence the persistence of poverty."

See also Tyler Cowen on Karelis here.

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