Poverty, Violence and Human Capital Formation

In recent years, there has been a growing commitment to studying the economic lives of the poor by better understanding their psychological lives (Banerjee and Duflo, 2007; Schilbach et al., 2016). These developments stem from the failure to empirically detect poverty traps, which have been at the core of the development literature for decades (Dean et al., 2017). Instead, empirical studies document the existence of very large rates of returns to investment, which, however, are not matched by observed consumption growth rates (Kremer et al., 2019). Several behaviors of the poor, which do not fit with traditional models, puzzled economists. Why do poor micro-entrepreneurs keep borrowing at extremely high interest rates instead of saving some of their profit to borrow less with each passing day (Ananth et al., 2007)? If using fertilizer has such high rates of return, why don't poor farmers purchase it (Duflo et al., 2008)? If the poor remain poor because they do not get enough calories, why do they spend their money on other things besides food (Banerjee and Duflo, 2007)? Such questions led to the rise of the subfield of Behavioral Development Economics, which applies insights from psychology and behavioral economics to study the economic behavior of the poor; trying to explain why and how it departs from standard economic models. Behavioral biases, studied extensively in Behavioral Economics, may be much more consequential for the poor. Failing to resist to the temptation of a hedonistic reward after a hard day of work will have very different implications for a poor person than for a rich one. This thesis aims to contribute to this new strand of literature, in particular to one of its branches titled "the psychology of poverty", which studies the impact poverty has on cognitive function and economic behavior. One influential theory in this field is the scarcity/mental bandwidth theory (Mullainathan and Shafir, 2013), which states that poverty implies not only lack of financial resources, but also lack of mental resources to focus on other things besides pressing concerns. At any time, a poor person's mind will be preoccupied with worries about bills, school fees or health problems; and how to best manage all of them with very limited resources. While this makes the poor better at decisions regarding the pressing issue at hand (Mullainathan and Shafir, 2013), it also makes them neglect other important domains which may not appear urgent enough (Shah et al., 2012, 2015). While the theory may help explain many puzzling behaviors of the poor, up to now there has been little evidence on real-world economic outcomes. The first two chapters of this thesis try to bring the framework closer to real-world economic decisions even though restricted to the lab setting. The main challenge with studying the psychology of poverty outside the lab is the fact that even exogenous changes in income will affect several other channels besides mental bandwidth, making it very challenging to pin down the precise mechanism. Given this, the first two chapters are limited to varying mental bandwidth in a lab setting, keeping income fixed. The novel aspect is that the decisions participants make mimic closely everyday life purchasing decisions, involving real products. I note however, that due to limited funding and ethical considerations, in both chapters decisions are only weakly incentivized: only 1% of participants actually receive the goods they selected. The first chapter explores the relationship between the psychology of poverty, investment in human capital, and financial incentives. Empirical evidence indicates that the poor are less attentive parents, investing less in the human capital of their children (McLoyd, 1998; Evans, 2004). This contributes to the inter-generational transmission of poverty because investing in human capital has extremely high rates of return, highest in early childhood (Cunha and Heckman, 2007; Cunha et al., 2010). The question is why don't the poor invest more? Traditional answers to this question put the blame on lack of knowledge of parenting practices, wrong beliefs on the expected returns or lower altruism. We propose an alternative explanation based on the scarcity theory. Poor parents may fail to invest the required time and resources in their child because their minds are preoccupied with other more urgent concerns. When there is uncertainty about how the next bill will be paid, spending time doing educational activities with the child may shift out of focus. When such behaviors keep repeating on a regular basis, a gap emerges between poor and non-poor children in the amount of cognitive and emotional stimulation they receive. The challenge is how to test this hypothesis. Given the identification issues with disentangling such channels with observational data, we bring it to the lab. Parents of toddlers, living in the UK, are invited to participate in an online experiment. First, they are asked to answer how their family would deal with various hypothetical financial scenarios which vary in severity (hard for the treatment group, easy for the control group). Among the treated, the scenarios aim to bring financial worries to mind, trying to capture what people living in poverty experience on a regular basis. After completing the scenarios, parents receive a budget of pounds 30 to be spent as they choose in an experimental market on 3 types of goods: necessities, child investment goods, and luxury goods. Half of parents are incentivized to purchase more child investment goods by being offered a 50% discount. This treatment investigates if financial worries change how parents respond to such incentives, and is motivated by the results in Das et al. (2013) which find that accounting for household re-optimization in response to a policy is crucial when evaluating its effects. We find that the incentive increases investment in human capital among lower income parents only when financial worries are not salient. When worries become salient, low income parents do not invest more but instead use the additional money to increase their demand of necessities. In addition, they also lower their demand for luxury goods to zero. When no discount is offered, we do not find financial worries to lower investment, which is likely to be explained by floor effects. Among higher income parents, financial worries do not affect behavior. The effects among lower income participants are driven by those who were further away from their last paycheck at the time of the experiment - an indicator of real world monetary scarcity. This finding increases the external validity of our main results. The second chapter departs from studying the human capital of children, focusing instead on the human capital of adultsootnote{However, the behavior studied is likely to have negative externalities also on children (e.g. domestic violence).}. Addictive (or temptation) goods have been at the core of academic and policy debates for decades. With Becker and Murphy (1988), addiction was rationalized as a utility maximizing decision where the individual fully internalizes the costs of consuming such goods. In this framework, the only scope for intervention is to balance out the externalities -- the costs that individuals place on society through consumption decisions (e.g. healthcare costs). Gruber (2001) questioned theoretically and empirically the rational framework, showing that with inconsistent time preferences, individuals do not fully internalize the cost of their behavior. Further studies have confirmed these findings which increased the scope of policy interventions (Gruber and Kőszegi, 2004; O’Donoghue and Rabin, 2006; Allcott et al., 2019a). The most widely used policy tools to limit the over-consumption of temptation are "sin" taxes, popular among governments because they bring large revenues. However, such taxes have sparked debates regarding their effects on income distribution. Since the poor tend to spend a higher share of their budget on temptation, they are likely to pay a higher cost. On the other hand, they are also the ones expected to benefit more in terms of health by consuming less. Traditionally, such taxes were placed on tobacco and alcohol. Recently, several governments have started adding taxes also on the consumption of unhealthy foods, such as sugary drinks and beverages. Crucial to determining the effect of the tax is the elasticity of demand with respect to price and the degree to which individuals are not internalizing their choices (Allcott et al., 2019a). The second chapter integrates the economics of temptation with the scarcity theory, and investigates if financial worries affect (i) the demand for temptation and (ii) the elasticities of demand with respect to price (sin taxes). The first question is not straightforward in the scarcity framework. While poverty is scarcity of financial resources, it is also scarcity of immediate gratification. The poor have stressful lives and jobs which are often less rewarding and highly physically demanding. Compensating for these struggles is harder since they can only access a small set of potential alternatives to addictive goods (e.g. going to nice restaurant and travelling are not really in the choice set of the poor). Following a similar design as in the first chapter but with a less specific population (adults living in the UK), we randomly trigger financial worries before asking participants to choose between necessities and temptation goods in an experimental market. The basket of temptation goods offered includes tobacco, alcohol and unhealthy foods and we simulate "sin taxes" by randomly increasing the price of temptation by 10% or 20%. We find that triggering financial worries lowers the demand for temptation but also dampens demand elasticities. The effects are stronger among low income participants. When financial worries are salient, their demand curve is actually slightly upward sloping. The finding is puzzling: financial worries appear to limit over-consumption of temptation, but they also hurt the poor the most when additional taxes are introduced. We find suggestive evidence that both effects are mediated by an increased focus on urgent necessities. The first two chapters integrated the scarcity framework into public policies. The results are very consistent across studies and have clear policy implications. Among the poor, when monetary concerns are top of mind: (i) incentivizing investments in human capital may not achieve its desired outcome, (ii) (dis)incentivizing consumption of temptation through new taxes may harm the poor the most since they do not lower their demands in response to price increases, which leads, through taxation, to a transfer of funds from the poor to the nonpoor without having any corrective effects (see Bernheim and Rangel, 2004; Bernheim and Taubinsky, 2018). However, I must note that both chapters make only speculative policy recommendations given that they lack the normative counterfactual. Further research is needed to rigorously establish the welfare implications of financial worries. The third chapter takes a step back from economic decisions to studying how violence exposure affects cognitive function in children. Unfortunately violence and poverty are closely linked in a vicious cycle. Economically deprived neighborhoods are in general also more violent. In addition to monetary concerns, the minds of the poor are likely to be preoccupied with safety concerns. This study attempts to apply the framework in Mullainathan and Shafir (2013), focusing on security concerns instead of monetary ones. While the link between the scarcity framework and violence as scarcity of security is novel and up for debate, the chapter is closely connected with the literature on the impact of emotions on cognition and decision making (Loewenstein and Lerner, 2003; Lerner et al., 2003, 2015; Callen et al., 2014; Bogliacino et al., 2017). In a lab-in-the-field experiment, primary school children in El Salvador are randomly assigned to recall episodes of violence exposure before or after taking cognitive tests. I find that recalling violence exposure before taking the tests, increases cognitive performance by 0.2 standard deviations, effect significantly stronger for children reporting higher exposure. The estimates contrast previous findings on the effect of violence and cognitive function (Sharkey, 2010; Sharkey et al., 2012; Bogliacino et al., 2017) and call for further research in the field.