Perspectives on the Economics of Poverty

Income inequality is a global issue affecting the industrialized and developing nations alike. Recently while traveling, I spent some time reading two books, Poor Economics and Why Nations Fail, which both touch on the issue of modern poverty. I’ve summarized a number of key insights here.

The central points of both Abhijit Banerjee and Esther Duflo’s book, Poor Economics and James Robinson and Daron Acemoglu’s book Why Nations Fail consist of the analyses of how economics applies to the poor, and how political institutions and actors exert a significant force on the economy and its impoverished inhabitants. B&D’s approach in Poor Economics utilizes a multitude of statistical data to explore the rationale of the poor when making economic decisions. For instance, one interesting finding reported in Poor Economics refers to the fact that the poor of Zambia, who, despite knowing about the benefits of chlorinating water and of an incredibly affordable chlorine bleach brand, Chlorin, overwhelmingly refuse to buy and use this essential health solution.

Meanwhile, R&A focus more heavily on the effect of government and politics on the outcomes of a nation’s population. The central point of their analysis in Why Nations Fail revolves around the role that “inclusive” and “extractive” institutions play in shaping economic outcomes. Specifically, the authors examine the dependence of economic prosperity on the existence of inclusive institutions and the damaging results of extractive institutions. R&A claim that such a framework may explain the economic contrast between North and South Korea since their split in 1953.

One of the critical ways in which Poor Economics differs from the Why Nations Fail model of inclusive and extractive institutions arises from the fact that B&D provide a model that allows for actionable initiatives whose level of success are also measurable through statistical analysis.

B&D achieve this result by focusing solutions on specific sets of isolated causes that produce strong influences in the economic behavior of the poor. Also important to this interpretation is the assumption of a poverty trap, which exacerbates the conditions of poverty. The trap predicts that a portion of a population will earn a future income will be less than their present income becoming perpetually poorer as a result of their present circumstances (S-shaped model).

By integrating this causal model with the idea of a poverty trap, B&D are able to break down the overall issue of poverty into a number of substituent factors surrounding how the poor conceptualize healthcare, education, and risk. While B&D caution that there is no universal answer as to whether a poverty trap actually exists, they stress the importance of the model’s relevance to understanding and alleviating specific problems through policy aimed at a few key factors that contribute to a poverty trap in a specific context.

On the contrary, R&A approach the issue from a generalized perspective that focuses closely on the impact of institutions rather than the thoughts of the individuals. The generality of R&A’s thesis regarding the sources of poverty weakens the precision of their argument and its ability to generate and measure solutions, as will become evident later in Fukuyama’s criticism regarding the vagueness of what constitutes inclusive or extractive institutions. For now, let us begin by considering how B&D construct solutions to aid against poverty traps by utilizing the economic thought of the poor at the private and institutional level.

In Zambia, Chlorin is named in 98% of cases where Zambian villagers are asked to name something used to cleanse drinking water, and Chlorin is significantly cheaper than most everyday products that Zambians use, such as cooking oil (800 kwachas per month for Chlorin vs. 4,800 per week for cooking oil). Given the relative prices of these two products in comparison to the utility that they provide, one would expect Zambian families to be regularly buying Chlorin. Instead, B&D show only 10 percent of the population uses bleach to treat their water.

‘Poor Economics’ by Abhijit Banerjee,‎ Esther Duflo. 320 pp. PublicAffairs

Why? The solutions that B&D provide in these cases answers the questions relating to why the poor do not purchase and use these basic, cheap, and powerful healthcare resources. B&D characterize the healthcare problem as the poor often choosing to ignore the accessible public health resources available to them during the time at which they first notice symptoms of sickness, only to resort to the services of expensive, private doctors when their health problems become life-threatening. A clear example appears in the Udaipur District of India, where a clinic with trained staff is only a mile and a half walk away, yet: “…the poor mostly shun the public health-care system…Of these visits, less than one-fourth were to a public facility. More than one-half of visits were to private facilities. The remainder were to bhopas — traditional healers who primarily offer exorcism from evil spirits.”

These statistics show that the poor are reluctant to use public health services early, opting for more expensive private practices or even spiritual healers in the future when their problems worsen. B&D explain that these seemingly incomprehensible and destructive behaviors are linked to how the poor conceptualize present costs and future benefits: “Our natural inclination is to postpone small costs, so that they are borne not by our today self but by our tomorrow self instead.”

Moreover, understanding how the poor conceptualize cost with respect to time gives important insights into solutions for increasing attention to basic health care. These behaviors arise due to the time inconsistency of the poor with respect to the cost of healthcare. Therefore, suitable policy solutions should address the resolution of that time inconsistency.

A key observation made by B&D is the fact that small costs discourage the poor from seeking life-saving interventions, while small incentives have just the opposite and positive effect. This observation stems from an understanding that the poor value present costs much more than future consequences. This weight given by the poor to present costs, despite the fact that the future consequences of not paying those costs (e.g. disease resulting from a lack of vaccination) is drastically higher, explains the counterintuitive behavior such as not purchasing Chlorin, bug nets, or visiting credible and accessible public health clinics in the local area. Furthermore, B&D remark that: “The 2 pounds of dal works because it is something that the mother receives today, which compensates her for the cost she bears for getting her child immunized (the couple of hours spent bringing her child to camp or the low fever that the shot sometimes causes).”

The use of small incentives such as 2 pounds of dal to balance out the perceived costs of acquiring healthcare necessities highlights the underlying economic logic of the behavior of the poor. Already, it is apparent how knowledge of the economic thinking that dictates the behavior of the poor may be used to create effective policies that result in considerable benefits, such as increasing the use of available healthcare.

Moreover, it is essential to consider how institutions shape poor economic thinking, in addition to more private issues like healthcare as discussed above. B&D explain that one of the primary concerns of those involved in agricultural, business, or industrial work is risk. In fact, the authors frame the level of risk for impoverished business owners as exceeding that of hedge-fund managers on the basis that “no hedge fund manager is liable for 100% of his losses.” The inherent level of risk associated with business in poverty not only affects food and income, but also impacts health, political violence, crime, and corruption. The income graph of Ibu Tina’s business before and after a robbery exemplifies the relationship between risk and the poverty trap, where the robbery reduced the operating capabilities of the clothing business to a point where it could no longer provide services at the same volume or frequency.

Due to the level and scope of such risk, poor economic thought prioritizes sacrificing profit and marketability for protection, and this sacrifice is often not enough to compensate for larger shocks to businesses such as natural disasters or theft. B&D document various coping mechanisms by poor business owners and farmers, such as using more conservative but less efficient farm inputs to compensate for erratic patterns of rainfall or diversification of investments in the land of others, which also creates inefficiency.

‘Why Nations Fail’ by Daron Acemoglu,‎ James Robinson. 544 pp. Currency

The effect of such conservatism worsens circumstances contributing to a poverty trap, as reduced sales from inefficiencies reduce income. It also makes the poor more vulnerable to sudden shocks as they have less income to endure such circumstances. Though B&D do not have a comprehensive or proven solution to these institutional inefficiencies, understanding the existence of and rationale behind such behavior is significant in beginning efforts to formulate a solution.

In contrast, in Why Nations Fail, R&A approach the issue of the causes of poverty from an institutional perspective, using comparative case studies between countries to illustrate their points, and do not emphasize the role of the individual as much as B&D. In fact, the behavior of individuals is viewed as a function of the political background of their native country. For example, R&A explain the differences in entrepreneurial initiative and creativity between teenagers in North and South Korea as deriving from the conditions imposed on their life and schooling by their government.

The authors remark: “Countries differ in their economic success because of their different institutions, the rules influencing how the economy works, and the incentives that motivate people.”

The framework that R&A subsequently develop to model how exactly political and economic institutions influence the economic outcomes of their population is based on the distinction between an inclusive and an extractive institution. Inclusive economic institutions are based in secure private property, the presence of an unbiased legal system, and a free market, while extractive institutions are designed to “extract incomes and wealth from one subset of society to benefit a different subset.” Similarly, inclusive political institutions are centralized and pluralistic while extractive political institutions concentrate power in the hands of a small elite class and do little to limit the exercise of that power.

The thesis of Why Nations Fail centers around how negative economic outcomes emerge from the dominance of extractive economic and political institutions, while positive economic outcomes originate from the dominance of inclusive economic and political institutions. It attempts to explain the importance of the origins of these institutions: inclusivity often promotes an incentive structure that encourages technological advancement and education, which are key factors for economic growth and the skill and competency of a workforce.

On the other hand, the uneven distribution of economic and political power associated with extractive institutions is unsustainable in the long run. R&A cite the seemingly paradoxical growth of China in recent years as an example of how a nation with mainly extractive institutions may prosper, but cannot do so indefinitely.

The most noteworthy similarity between the theses of Poor Economics and Why Nations Fail appears in the overlap between how B&D portray the poverty trap and how R&A characterize extractive institutions. The poverty trap arises in circumstances that result in a continually reduced future income for an individual in comparison to their present income: not being able to work due to health issues, then not being able to obtain adequate health care due to income losses from not being able to work, or losing the ability to generate the level of income of a previously successful business due to a chance disaster.

Similarly, extractive institutions appear to create circumstances under which a population is subject to the effects of a poverty-trap-like economic outcome. This is to say that the extractive institutions reduce the ability of a part of their population to generate income over time. R&A’s reference to the unsustainability of the current growth of Chinese business under extractive institutions illustrates this idea of a declining potential for growth: “The most likely scenario may be for the Chinese Communist Party and the increasingly powerful Chinese economic elite to manage to maintain their very tight grasp on power in the next several decades… the spectacular growth rates in China will slowly evaporate.”

The most important disagreements and criticisms for both of these explanations of poverty relate to the scope at which each of these authors define their model and solutions. Why Nations Fail’s lack of reflection on how individual behavior influences poverty is one way in which R&A’s institutional framework oversimplifies the issue of poverty.

In fact, in his criticism of Why Nations Fail, Francis Fukuyama alludes to this issue of scope explicitly: “Since each of these broad terms (inclusive/extractive, absolutist/pluralistic) encompasses so many possible meanings, it is very hard to come up with a clear metric of either. It also makes it hard to falsify any of their historical claims… any given degree of growth (or its absence) can then be attributed to ether inclusive or extractive qualities ex post.”

In short, with how broadly R&A have defined inclusive and extractive institutions, it is impossible to prove for certain that one set of institutions caused a nation’s economic growth or decline. Fukuyama proceeds to give a number of examples to show how these definitions are problematic because of their breadth, such as how the inclusivity of Indian politics hinders major infrastructure construction initiatives. Inclusivity does not always benefit economic growth, since expanded political participation hurts growth if political institutions do not appropriately develop as well.

By comparison, the authors of Poor Economics are much more specific in their definition and the scope of a model and solution concerning poverty. B&D do not intend to characterize the causes of poverty or a poverty trap in general terms, but instead intend to investigate parts that contribute to poverty in specific cases, so that a policy may be identified and applied locally: “The lack of a grand universal answer might sound vaguely disappointing, but in fact it is exactly what a policy maker should want to know — not that there are a million ways that the poor are trapped but that there are a few key factors that create the trap…”

This method of characterizing poverty is more concrete than the mainly theoretical assertions that R&A make in Why Nations Fail. It allows policymakers to approach and focus on one issue, health for instance, and create practical policies based on research that alleviate factors contributing to poverty traps.

B&D’s description of how a compensation-based healthcare system significantly changes healthcare compliance among the poor produces a much greater improvement on poverty than R&A’s framework that draws conclusions about the relationship of poverty and institutions. The approach suggested in Poor Economics is more reasonable because its scope is limited to specific communities and because it produces measurable progress for the impoverished by basing policy on research and an understanding of how the poor think differently.