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You might think that if you were to hand out money to someone with no strings attached, that person would lap it up and be grateful to you for it. Both common sense and standard economic assumptions of rationality would suggest such an outcome. Yet, researchers at GiveDirectly Inc.—a non-profit organization that provides unconditional income transfers to poor people in Africa—were surprised to find that many people refused to accept the cash when they were offered such a deal.

While the programme has been well received in most regions with more than 90% of the people who were offered cash accepting it, problems have started to surface in particular regions where people refuse the cash. In the Kenyan region of Homa Bay, the rates of rejection are as high as 45%. When GiveDirectly started looking into the issue, they found that these people have reservations about the “free money". Some find it hard to understand why they are being given money without any fine print. Some of them believe that this money is associated with the devil.

It is easy to dismiss this as a one-off example in that region were we not confronted with a range of economic transactions and situations where beliefs and perceptions have a direct and powerful impact on our decisions.

Psychologists, sociologists and political scientists have recognized, for long, the importance of beliefs in shaping human behaviour. Experiments from psychology indicate that people have systematic biases. For example, interviews of bettors at a race track indicate that someone just leaving the betting window places much higher bets on a horse than someone in the queue just prior to placing a bet. Borrowing from these arenas of social inquiry, behavioural economists have tried to posit an alternative explanation of economic behaviour, based on a “heuristics and biases" approach to explain economic decisions.

A new stream of economic literature, which falls somewhere in between the mainstream model of rational economic agents and the heuristics and biases approach of behavioural economics, seems to be gaining prominence now. This approach has been christened as “motivated beliefs" to emphasize the joint influence of both reasoning and biases in making economic decisions.

Summarizing the latest issue of the Journal of Economic Perspectives which is dedicated to this topic, the editor of the journal, Timothy Taylor, writes, “The theory of motivated beliefs fall in between these possibilities (of rational agents and biased agents). In these arguments, people are not strictly rational or purposeful decision-makers, but nor does their decision-making involve built-in flaws. Instead, people have a number of goals, which include fitting in with their social group, feeling moral, competent, and attractive, and achieving higher social status".

“Sometimes reasoning directed at one goal undermines another," write behavioural scientists Nicholas Epley and Thomas Gilovich in the aforementioned journal. “A person trying to persuade others about a particular point is likely to focus on reasons why his arguments are valid and decisive—an attentional focus that could make the person more compelling in the eyes of others but also undermine the accuracy of his assessments. A person who recognizes that a set of beliefs is strongly held by a group of peers is likely to seek out and welcome information supporting those beliefs, while maintaining a much higher level of skepticism about contradictory information… A company manager narrowly focused on the bottom line may find ways to rationalize or disregard the ethical implications of actions that advance short-term profitability.

“The crucial point is that the process of gathering and processing information can systematically depart from accepted rational standards because one goal—desire to persuade, agreement with a peer group, self-image, self-preservation—can commandeer attention and guide reasoning at the expense of accuracy. Economists are well aware of crowding-out effects in markets. For psychologists, motivated reasoning represents an example of crowding-out in attention."

The role of beliefs in economics has been emphasized in recent years primarily by behavioural economists, who have relied on advances in psychology but the idea that beliefs and sentiments shape how we live and transact is an old one, whose roots can be traced back to the writings of the father of economics, Adam Smith.

In his lesser-known work, The Theory of Moral Sentiments, Smith wrote that, “the great pleasure of conversation, and indeed of society, arises from a certain correspondence of sentiments and opinions, from a certain harmony of minds, which like so many musical instruments coincide and keep time with one another".

All is well, until people realize that their belief sets are different. In one of the earliest formulations of this idea in terms of a mathematical model, economists George Akerlof of the University of California, Berkeley, and William Dickens of Northeastern University formalized this idea into a simple model and showed that not only do people have preferences for beliefs, these preferences persist. Such differences can have profound consequences on how we assess ourselves and others. In a 1995 paper, the celebrity economist Thomas Piketty showed that income inequality for a given, homogeneous cohort could grow with age. Learning, taking pains to understand different world views or internalizing data are costly. People are prone to settle on incorrect beliefs, he said.

“When people are young and start with the same beliefs, they put forth the same effort, and the only inequality comes from the shocks," wrote Piketty. “As time passes, people who have received bad shocks may get (rationally) discouraged and supply less effort; whereas more successful agents keep putting forth more effort. Eventually a lot of persistent inequality has been created simply because of endogenous belief dynamics. This provides a new explanation for this widely noted phenomenon."

How do people trick themselves into holding on to beliefs that may be inaccurate or defy reality? The Nobel-winning economist Jean Tirole of the Toulouse School of Economics and Roland Benabou of Princeton University in their new paper earmark three channels.

The first is about avoiding bad news or any kind of information that could cause discomfort to us. Benabou and Tirole label this as strategic ignorance. People, for this particular reason, choose not to test for HIV or other deadly diseases. Economist Emily Oster of Brown University collaborated with Ira Shoulson of Georgetown University and E. Ray Dorsey of University of Rochester to test this issue. The trio looked into testing for a genetic disease known as Huntington disease, a hereditary neurological disorder, and found that many of those who are at greater risk of contracting Huntington disease refused to test.

The other way in which people (mis)use beliefs is by refusing to internalize any information that could cause distress, even when there are enough red flags. People simply opt for reality denial. For instance, in case of an impending housing bubble, many disregard warning signals and start showing signs of, to use Nobel laureate Robert Shiller’s phrase, ‘irrational exuberance’.

People might also selectively act to feel good about themselves—an act of self-signalling—even though the action may cause some harm to them. In November 2011, New Zealand cricketer Martin Crowe announced a surprise comeback at the age of 48. The comeback lasted precisely three deliveries, with Crowe pulling a thigh muscle. Self-signalling is to be blamed here.

The economic consequences of beliefs, most notably on economic discrimination and inequality, tend to be persistent, suggests a growing body of research.

Beliefs about productivity have long-lasting effects on persistent social inequities. In a 2003 study, World Bank researchers Karla Hoff and Priyanka Pandey ran experiments among high school students in Uttar Pradesh in which the participants were asked to solve mazes in two 15-minute rounds. They find that when caste identity wasn’t known, there was no discernible difference in performance across caste groups. However, when subjects’ caste was made public, only those from the lower castes performed much worse. Loss of self-confidence and the belief that they won’t be fairly rewarded were the reasons for the poor performance among those from the lower castes.

In a 2009 paper, Devah Pager, a sociologist at Harvard University, and Diana Karafin of New York University presented their results from a survey of hiring managers in the US to examine the attitude of employers towards workers from different races. They found that discriminatory racial attitudes persist even when blacks perform as well as (if not better than) whites on the shop floor.

“We know from the results of field experiments that employers consistently avoid black workers, hiring them at roughly half the rate of equally qualified whites," wrote Pager and Karafin. “Where models of statistical discrimination might interpret this behaviour as the rational response to observed differences in the productivity of black and white workers, the present research questions this conclusion. The majority of employers who report positive experiences with black workers (or no differences between black and white workers) nevertheless maintain strong negative attitudes about black men generally. To the extent that these attitudes shape hiring decisions, even in the scenario of equal productivity among black and white workers, we would expect the problems of hiring discrimination to persist well into the future."

Beliefs also affect attitude towards inequality. Alberto Alesina of Harvard University and others used the World Values Survey data to show that Americans are twice as likely as Europeans to believe that the poor are “lazy or lack willpower" and that “in the long run, hard work brings a better life".

While the attitude of those who are better off is expectedly negative towards inequality, how do the beliefs of the poor change when they receive a windfall? In 1981, about 1,800 households illegally occupied wastelands in a part of Buenos Aires, Argentina. Some of these squatters received property rights from the government in 1984. Rafael Di Tella, an Argentinian economist at Harvard Business School, and his colleagues studied the change in attitudes of the squatters towards market outcomes.

Those who got lucky were also more likely (than the ones who did not receive any rights) to “hold beliefs that we describe as individualist, materialist and consistent with social capital accumulation". Likelihood of supporting policies towards redistribution, Di Tella and others show, is also a function of personal fortunes.

Standard economic theories suggest that people learn from their mistakes, internalize new information, and become less prejudiced over time. The theory of motivated beliefs suggest that some beliefs may be more resilient to change. This theory shows us why we often make systematic errors: why we may sometimes refuse to test for a potentially life-threatening disease, and why we may sometimes over-invest in markets.

“The theory of motivated beliefs still views people as motivated by self-interest," writes Taylor. “However, the dimensions of self-interest expand beyond the standard concerns like consumption and leisure, and encompass how we feel about ourselves and the social groups we inhabit. In this way, the analysis opens up insights into behaviour that is otherwise puzzling in the context of economic analysis, as well as building intellectual connections to other social sciences of psychology and sociology."

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