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MIT OpenCourseWare at ocw.mit.edu. PROFESSOR: I think at the
beginning of the semester we have kind of sketched
out the broad plan. And the broad plan was to move
kind of progressively from what are fundamentally
individual decision making problems to thinking about more
problems of the market. And we're going to try and do
insurance, which is obviously something to do with markets. So here is by way
of background. You probably remember a few
years ago the world economy was in crisis. It may still be in one. But now we're told it's not. So this is a quote from the
president of the World Bank. He's trying to make the case
that the crisis in 2008, 2009 was going to be a particular
crisis for the world's poor. And that's not implausible. You might imagine that if you
are that much closer to survival, you have fewer
resources, then anything that goes wrong is likely
to hurt you more. So that's not an implausible
idea. I spent a couple of days with a
New York Times reporter, the New York Times bureau chief
in India, in the pursuit of this story. So I was going for something
else, and she came along with me. And she was looking for
people who had-- this was a part of rural India,
a very poor part of rural India. And her whole idea was that
she's going to go there and, like Zoellick, she was wondering
how these people in the villages who go to the
city to work as maybe laborers, how they
would be affected by this global crisis. This is the New York Times. So she wanted to link up what's
happening in poor parts in rural India with what's
happening in New York. So that made perfect sense. And the problem was that nobody
seemed to know there was a crisis. So she would go and ask people,
so have you heard about this? There's a crisis in the world. Is that affecting your
job prospects? And one striking fact was this
was in a part of rural India that's pretty backward. The areas we were were mostly
conservative, mostly families. A lot of the migrants
had come home for a bustling religious festival. So a lot of the migrants
were there. We could talk to them. And to the man, literally to
the man, they said, no. What crisis? There are jobs for anybody
who wants a job. So we went to the train station
for migrants coming back from having lost their
jobs in the cities. In fact, we found tons of
migrants who were leaving for the city on the train. So basically the story never
got written, and New York Times never had this story
because there was never anything to be found. And it was kind of striking how
disjointed these two world views were. Now, that doesn't mean-- I think it was clear that if you
looked at the data, there were people who were
losing jobs. Some construction projects
had been shut down. There were certainly some
jobs being lost. I think the real reason why
this didn't show up in people's kind of intellectual
map as a very big deal is not because some bad things
were not happening. But it's more that they're used
to having jobs being lost and having to find jobs and
things like that as a normal part of their life. In other words, the amount of
risk that they normally bear is so large relative to our
perception of risk-- I'll show you some numbers in a
bit-- our perception of risk that this was seen as, you
know, normal turnover. Certainly some jobs were
being-- but you find another the job. And the basic difference came
from, I think, their calibration or what is
unreasonable amount of risk. Our colleague, Rob Townsend who
is an expert on Thailand, studied the Thai economic
crisis of 1998. So this was a big deal
in Thailand. I mean, there was like the Thai
baht I think halved or more than half. I mean, it just grew. And the whole economy-- several banks came close
to failing and had to be bailed out. All kinds of bad things
happened. Rob Howard doesn't
study the banks. He studies the people
who live in poorer parts of northern Thailand. And he has a panel of
people now for more than, I think, 12 years. But he had a long time he had
been following these people, 15 years something. He's been following the people
for a very long time, families, and looking at
the economic outcomes. So every few months, they go
back to the same families and measure a bunch of stuff. And the same families
are maintained for a very long time. It's a unique data
set that he has. Now, one advantage of that data
set is you can look at what happens in the crisis year
relative to what happens in other years. You have a data set of
the same families for a very long time. Just descriptively you may just
ask what changed in the crisis year? And I think his number, which
he presented this at a conference before he came to
MIT-- and I had to be the commentator-- the number, in a sense, it
was almost unbelievable to think about it. So he found that 2% of the
variation in their income was attributable to the crises. The 2% of the variation of
income in these families-- so if you look at a family, his
income varies every year, every six months. So you can just look at the
total variation in income. And then you can attribute
a particular part of that to the crisis. What was extra in a crisis? And I think his calculation
was about 2% more for the crisis. The reason I make that point
is not to say that the poor are very, very well off, but
the opposite, that their normal exposure to risk is so
high that this additional piece that come from global
crises is an extremely small part of it. I think the way to think about
it is that there's a ton of risk that any poor person
bears all the time. And then there's some stuff that
happens which we think are important like what's
happening in New York and the important for MIT. MIT, as soon as the crisis
hit, the first thing that happened is that we used to get
free lunch on Mondays and Tuesdays and that
was shut down. So it was very important. We got some risk from that. But if you think of these
people, they're not getting any free lunches in any case. And so the amount of uncertainty
that they deal with on a day to day basis
dwarfs any uncertainty that might come from specific
episodes like the Thai banking crisis of 1998. Do you have question? Somebody had their hand
up for a moment. AUDIENCE: Do we have
evidence from other places besides Thailand? Because, I guess, popularly
speaking, a lot of people talk about the loss decades in Latin
America and how bad that was, you know, for people's
ability to generate livelihoods. So I'm just wondering if we
really have a lot of evidence that this is really a
broad phenomenon. PROFESSOR: So I think
there are two parts to what you're saying. Both are important. One is do we have evidence
from other countries? Second is part of the reason
why this population is different is that Thailand
is a lot less urbanized than Mexico. So many more people in Thailand
operate in the traditional underdeveloped
economic mode, which is that they are self employed,
they have a farm, something like that. So let me give you a different
example, which is maybe even more revealing. This is taking me a little
further [INAUDIBLE], but it's interesting. So there's a study by one of
our ex students of what happened in the Indonesian
crisis of 1998, which happened for the same reason. And there the Indonesian rupiah
devalued by a factor of three, which is a huge amount
of devaluation. So something really
big happened to the Indonesian economy. So turns out that the real
incomes of anybody in Indonesia who was mainly a rice
farmer went up during this crisis. The reason is that suddenly the currency devalued massively. What happens when the currency
devalues and you're in rice? Well, rice is a trade-in good. Its price goes up relative
to non trade-in goods. So your hair cut prices don't
go up, but rice prices go up because rice is traded. So these rice farmers actually
were better off in the Indonesian crisis than
they were before. He then looks at, well,
how do they react? And the thing he's looking at
is people attending Koranic reading classes as well
as the outcomes. And the basic reason he's
interested in them is he thinks that this is a social
support mechanism. Who start attending Koranic
reading classes? It's the people who are
not rice farmers. It's the government employees,
teachers, anybody who has a fixed income. They are the ones who lost. And then the people who were
farmers, they actually were better off. And they were actually less
likely to attend Koranic classes during the crisis. So in other words, again, a
lot of people in a country like Thailand or Indonesia are
basically farming dependent. And those people have very
different risk patterns from the urban employees. Latin America is
very different. Latin America is massively
richer also then Indonesia, for example. Peru is three times richer than
Indonesia, per capita income, at least in
dollar terms. It's also much more urbanized
with a labor force. So I'm sure the lost
decade happened. I'm sure that a lot of urban
workers in each of these countries gets hurt. The main point I'm trying to
make here is that there's also a whole bunch of people in these
countries who bear a huge amount of risk even when
there is nothing happening in the world economy. And those are people who are
farmers, who are laborers in construction, people who
sometimes get a job helping out in farms, these kind of
people, landless laborers or different kinds. These people have a very
different risk pattern than the urban workers who tend to be
the people who are directly hurt by big global shocks. So there was not that there
were people not hurt, it's just there were, for many of
the people that [INAUDIBLE] Rob Townsend was studying, all
kinds of stuff were happening in their lives. These were all farmers. And lots of them were-- all kinds of stuff were
happening in their life, many of them very bad. And this was just a small
piece of that big story. That's the point that I think
is worth emphasizing is that there's just much diversity,
and there's so much risk. So basically what are
the sources of risk? I think the biggest single risk
is just being a farmer. If you're a farmer, you'll
face huge amount of risk. What do you face risk from? What's a main source of risk? AUDIENCE: Bad harvests. PROFESSOR: Bad harvests. How do you get bad harvests? AUDIENCE: [INAUDIBLE]
rainfall. PROFESSOR: Rainfall, bugs,
you know, locusts. If you're a farmer, you're used
to dealing with a huge amount of risk. I mean, by our standards of the
kind of risk that tenures professors face--
of course, maybe that's an extreme example. They have a huge amount
of year to year variation in income. Even those who don't have
a farm, most of them are casual labours. The poor in most countries,
in poor countries, are casual laborers. Casual laborers meaning they
don't have a contract. They have a daily job. The typical way you get a job
is in a city you stand at a street corner and somebody who
needs someone to move boxes comes and picks up 50 people
and takes them somewhere. So it's extraordinarily casual,
meaning at a given day, you may not get a job. And many of these people are not
employed more than 15, 16 days a month. So this is a very,
very common fact. And there's lots of
uncertainty there. Some days, some months you maybe
get unlucky and you just got there late or something,
and then you missed your chance. So the amount of uncertainty
that you have if you are kind of a casual laborer in a
developing country is huge because its the uncertainty of
in any given day you have a probability of, let's say,
three out of four of getting a job. And the other days you don't. And so if you look at daily
income, daily income is extraordinarily variable for
most of these people. And it's just mechanically
almost. Somebody shows up at that street
corner and, you know, they ask you to get on the truck
and go with him, and he needs 10 people today
rather than 15. You don't get a job. So this is just a core level of
risk in this life, which is very different from thinking
about the kind of risk we think about most of
the time in a more developed country context. There's no social protection. The other side of that is
there's no social protection or almost no social
protection. So one way to think
about this is-- this is wage volatility. This is how much your
wages vary. And this is not day
to day variation. This is year to year variation
across a set of countries. This is real wages. So the poorest country
is Myanmar. And basically you can plot
a line and that line has essentially-- if you increase raw GDP by
one, you halve the risk, something like that. So this is conditional
on getting a job. I said the big part of the
uncertainty is you just don't get a job. But then the real wages are
extremely unstable as well. Part of the reason they're
unstable comes from this other fact, which is this. This is food prices. And if you spend 60% of your
income on food, food prices matter a huge amount. One big piece of risk that
people have been facing is just what's happening
to food prices. So food prices have gone-- as you can see, 2007,
they peaked. The dollar food index
went up to 200. It came down to 140 then went
up, bounced around, and has been climbing since. So that's a 60% change in the
food price in a year-- not 60. Sorry. It's a change from 140 to 200. So that's a change of 30%. And if you spend 60% of your
income on food then that's of the order of, like,
losing 20% of your income in a given year. So just food price variation
will itself have consequence. Now, wages probably adjust,
so that's probably an overestimate of that. But still, you can see one major
source of uncertainty comes from just the fact the
food prices go up massively sometimes and come down. With up and down it's
risk that you see. There's also a trend which is
worrying in general is the food prices seem to be going
up systematically over the last some years. What is a bit misleading about
that trend is that food prices had fallen for the previous
35 years or something. Food prices had fallen. So since 1970 to 2005, food
prices had basically systematically fallen
slightly, and then it's been going up. So this is a bit misleading,
this picture. But still, there's lots
of uncertainty. The thing I want to emphasize
here is not levels but uncertainty. Food prices bounce
around a lot. If you're poor, that's a very
big piece of your income. So just to think about this
analytically, risk also matters very much depending on
where you are, for example, in your production cycle. So a reason why risk is
amplified is when-- the fact that you get hit by
a shock then effects your ability to productive, which
then affects your income, which then affects your
ability to be productive, et cetera. So there is potentially a
vicious cycle that can be set off by a shock. When would that happen? Well, we have introduced
this idea of an S-shape production function. Have we read [? Ebutina's ?] story? What's the story? AUDIENCE: It's about a woman
who used to own a small business with her husband in
which they had a kind of garment manufacturing company,
which they had a bad contract which caused them
to go bankrupt. And that led to a divorce. They tried to restart the
company before divorcing. They restarted the company with
limited funds and bought a bunch of shorts that
they packaged and were going to sell. But that fell through,
led to a divorce. The woman has the children
living with her parents, and they're just in absolute
poverty now. PROFESSOR: Yeah. So the thing to emphasize there
in that story is that this particular kind of shock
she faced was a contract enforcement shock. She had two shocks, both of
which where basically-- so the first one was someone
she had basically sold on credit defaulted and therefore
didn't pay back the money. And she had taken a loan
to finance that. So that kind of put
her into trouble. Then she got an order to supply
shorts to, I think, a retail store. And then they defaulted
on that. They refused to take
the shorts. So when we met her, she had
a huge pile of shorts. They were sitting inside her
house surrounded by a pile of shorts, like, a lot of shorts,
12,000 shorts or something. So she lost a whole bunch of
money on that as well. The point is that what is also
striking about her story is this dynamic. So what this picture does-- so it's like that
S-shaped curve. S is maybe an exaggeration. That's a mapping from
your wealth today to your wealth tomorrow. So that tells you given today's
wealth what tomorrow's wealth would be. So let's take that as given. And now the main point of
drawing it that way is that if you think of what's happening
around the point, P-- look around the point, P. Think
of a part that starts just above P. Where's
that part going? AUDIENCE: [INAUDIBLE]. PROFESSOR: Explain. AUDIENCE: To the second
intersection up there. PROFESSOR: Right. Any part that start to the right
of P, you can see that-- like the one example that's
drawn, the way to analyze this is to think you start with
a particular wealth. That generates that
wealth tomorrow. That wealth is the same. So tomorrow's wealth then
becomes today's wealth. The way you do that is you map
that to the 45 degree line, and you look at wealth
that will be. And that sequence is just going
up to the point where the second intersection is. Who doesn't understand
this picture? I'll explain again because
we'll come back to this picture. OK. I'll assume that you're
comfortable with this picture. I'm not surprised,
but just in case. And then what's key is that if
you're the other side of P, you're going the other way. So if you're close to P and you
get hit by a shock, your wealth goes down by
a small amount. That's not where it stops. Your wealth goes up by a small
amount, you go up a long way. Your wealth goes down by
a small amount, you go down a long way. So there's a natural
amplification. If the production technology
looks like that, then there's a natural amplification
of a shock. A small shock turns into
a big shock here. That's the point of
that picture. So now it's very difficult for
her to get out because basically she's never generating
enough surplus to make the investment she needs
to get the next period's output to be high enough. So she's always, like, cutting
back and cutting back and cutting back. So, in other words, not only
is there a lot of risk, there's a lot of technologies
in the world which amplify that risk. So we already talked
about another aspect of it last time. What was that? Another aspect of risk, kind of
an amplification of risk. What happens? It's not quite an
amplification. We talked about what happens
during drought. Who was here? AUDIENCE: During droughts the
girl's more likely to be [INAUDIBLE]. PROFESSOR: Allowed to die. AUDIENCE: [INAUDIBLE]. PROFESSOR: You were going
to say allowed to die? Are you looking for that word? AUDIENCE: Yeah. PROFESSOR: It's an
awkward word. Yeah, exactly. So another aspect of this risk
is that you sometimes respond to it in drastic ways. So one of the drastic ways
you might respond is by-- why are you trying to do that? Because you know that
essentially if you have two children, you can't feed either
of them, both of them are going to starve and be hurt,
the long run, health will be hurt. So you kind of switch your
money to one of them. And that's another way in which
you sort of maybe create a long term problem. Maybe one of those children
doesn't die, but she starves and grows up as someone who has
a handicap all her life. So you amplify lots of shocks
by taking these extreme decisions under these
conditions. So this is just saying
that when you think that you can't really-- so balancing risk is difficult
if you don't have a lot of money. It's not surprising. Moreover, here's an
interesting fact. So this means stress, right? It doesn't just mean that
something happens to me. I also worry about it. It would be amazing if you
didn't worry about the fact that, you know, tomorrow you
might have to starve one of your children. So risk means worry. Now, it turns out that when you
worry, your body actually acts in a particular way. It generates cortisols. Cortisols are a body's kind of
defense mechanism to keep it going under situations
of stress. They are actually a natural
response of the body to a situation of risk. It's probably, in a sense, a
good reaction from the point of view of certain types
of survival. But there's a lot of lab
experiments where basically what they do is they
stress people out. So I think the one that-- there's a bunch of them with
Princeton students, who are not exactly the world's
poorest. But the way these experiments
go is they give you an endowment. And then they take away some
of that endowment. And somehow people get stressed
out when you do that. Even if, obviously, you're
a Princeton student. It's not that you're going
to run out of food. There's plenty of food
in the dining halls. And your lifetime income is
unlikely to be affected by the fact that you lost $5
in this experiment. But people get stressed out when
you put them into these situations. And then the experiment is to
make them play games, sort of, like, problem solving games. And you get a massive reduction
in their problem solving ability. Maybe they're not
MIT students. Maybe they're just not
as good at it. But still you see that they do
really badly when you put them under stress, so, like, little
bit of stress, some fake stress, basically. They were going to get $10
and instead they end up with $2 or something. And that kind of stress already
makes them take really bad decisions. You might imagine if you
had real stress. Your child could starve. Your mother could die. You could lose your job. You're not going to be
taking a lot of good decisions under that. Yep? AUDIENCE: In the experiment
was the endowment or money related at all to the outcome
of the games? Or was it just like they
were [INAUDIBLE]? PROFESSOR: No. These are separate. So the games were the games. But before the games, you
created some general unpleasantness for them. They thought they would get A
but they get B or something. One of the rules of experiments
is you can't make people worse off. So these people were
not made-- they were first given some
money, and then some of that money was somehow taken
away from them. So this was like somehow even
that got them so stressed out that they started playing
games badly. Melissa. AUDIENCE: How do you know that
it's not just that they're like, oh, this is a
stupid experiment? If I do well, they're just
going to take it away from me again. So I'm not going to
make any effort. PROFESSOR: How do I know? Because I think they believed
the experimenters. I don't think that they
thought that-- so they were told from the
beginning that when you join this experiment there will be
some uncertainty that's going to be created for you. So the experiment was done
relatively carefully to avoid the possibility that
they think this is just a mad world. I think most experimenters worry
about that, which is you come and tell me first that
we'll do this to you, and then I'm going to do that to you. You start worrying. But then there's a nice field
experiment actually in Kenya which is measuring cortisol
levels across people when they receive, I think,
some microcredit or some other program. I haven't seen the results
from it yet. But I've heard the results are
again very similar, that you're going to get
people under stress take bad decisions. So the advantage of doing it in
the field is that they're getting real help with
their stress. And when they get the real help
with their risk, they actually take better
decisions. It's less artificial. But I think this fact is quite
crucial in understanding a lot of decision making among poor
people because they are under a huge amount of stress. And then we're expecting them to
maximize utility over, you know, the rest of their lives
and figure out which financial investment to make and, you
know, how to educate their children and all of these
decisions and get all of them right. You might imagine that one of
the things that happens when you're under a lot of
stress is you get these decisions wrong. And if you get the decisions
wrong that obviously has long term consequences for your
life-- so one other sense in which risk affects you is by
making you take bad decisions. Yeah. AUDIENCE: But isn't it often the
case that for the poor the options are in many cases very
limited and, for example, if plant harvest fails, a lot of
people will just move to other areas or do labor? And they also have few
sources of credits. So if the crop fails, then this
will at least give people [INAUDIBLE] credit. So does decision making actually
understress actual figure very highly in decision
[INAUDIBLE]? PROFESSOR: I think the
answer is yes. I mean, I think at the beginning
of the semester we looked at, for example,
just consumption decisions of the poor. What we saw there was that
they were spending large amounts of money on things that
they didn't need to buy. So that's a very
simple example. Taking their child
to be immunized. Should I take him today or
take him in a month? And if I don't do it today, if
I'm fully forward looking, rational, I might decide, look,
I might as will do it today because I'll never
do it in the future. But if I'm subject to making bad
decisions, I might easily make a decision on that. Should I spend the effort
and the money to purify my water or not? I can miscalculate on that. I could think the
risk is smaller than it is, for example. Actually, I would almost put
it the other way around. I think we who live in-- rich people have most of
the decisions taken out of their hands. For example, I don't remember
taking any savings decision. Mostly my saving decisions
are taken by MIT. And then there's some plan which
I'm supposed to join. I joined that plan when I
joined MIT, and I've not changed anything. I don't have to plan
my retirement. I don't have any risk mostly. Unless I do something really
awful, I don't lose my job. So I never take many decisions
on, like, should I go look for a job there or there? I just come to my office
and I'm done. I don't have the choice of not
immunizing my children because to the extent that I want them
to go to school, the school basically enforces that. You can't get your children
to school without immunizing them. Most decisions of this
class are taken out. I don't know [INAUDIBLE] water supply. I turn on the water,
it's clean. I absolutely don't have to
take that decision on. Should I purify this water
before I give it to my son or not? It's a decision I don't
have to take. Why? Because the water's
infrastructure cleans before it reaches me. I get clean water, so I don't
have to worry about that. I don't have to worry about
whether or not my house can be made out of things which can
catch fire because before the house can be built an,
inspector comes and checks it out. And I'm not allowed to build a
house that can catch fire. So there's so many respects in
which I don't have any choices given to me. But if you're poor,
you actually have a thousand choices. I mean, I actually think there
are too many choices you have to make if you are poor. I mean, think of water. Every day you have to decide
should I clean the water or not? That's a difficult choice to
make on any given day. Yes, someone else
had a-- yeah. AUDIENCE: So how much of that,
though, can you attribute to bad decision making affected
by cortisol? And how much of it is because of
a basic misunderstanding of economics and utility and
the future return on something like that? PROFESSOR: We don't know
the answer to that. It's a very good question. One day we'll know the
answer to that. Like, this whole cortisol stuff,
we've only figured this out in the last two
or three years. We're just beginning to get into
these kinds of questions in a scientific way. Maybe in 15 years we'll know the
answer to that question. Right now this is one thing that
I think is very, very, very recent, this understanding,
this connection with cortisol and decision
making and then the fact that cortisol is related to risk. This whole thing
is very recent. So I don't know the
answer to it. It's a perfectly
good question. I just don't know. AUDIENCE: OK. PROFESSOR: Now, obviously
people don't take risks sitting down. They do stuff about it. So one thing you can do
is you can borrow. You can go and say, look, I
don't have any money today. The truck didn't pick me up. Why don't you give
me some money? And certainly people do that. We'll see that it's pretty
limited and very expensive. So the alternative is to save. So you can borrow. You can save. We'll come to insurance later. But mostly most people, they
do one of a fairly limited number of things. Now, savings is a pretty
good way to deal with-- so imagine that you face a lot
of risk and you can't borrow. Your decision rule more or less
should be the following. The optimal decision rule-- whether people can
figure this out. It took a Princeton economist
and a computer to figure this one out. So maybe people can't
figure it out. But let's say they can. Then their decision rule
should be to consume everything when your income is
low, everything you have. And then as soon as your income
crosses a certain threshold you should save the
rest and you should build up a stock for those days when
things go wrong. Problem is that if you get two
or three bad years in a row, this doesn't protect
you at all. And the next picture kind of
shows that a little bit. So this is a simulation. This is nobody real. This is a simulation of what
happens when you have income, consumption, and assets. So income is bouncing around. When income is high, you're
accumulating assets. Then at some point, when income
is low for a few years, your assets keep getting
run down. Some point it hits zero. Then if you're lucky and income
goes up right then, then you keep going up. Then your assets go up
and you keep saving. You're fine. But sometimes you can see that,
like in the middle, there is this place where income
goes down sharply, and it goes down like there's
several periods for which it's gone down, that sharp kind
of knife, you know, right in the middle. And you can see that what's
happened there is your assets have hit zero. And because your assets have hit
zero, there's no way you can just pull down your assets
and protect your consumption. There's nothing you
can do about it. And that's when you see
consumption really dropping. So most of the time you see
consumption is a lot flatter than income. And that's what people
find in the data. Consumption, in general, is very
flat relative to income. But there are periods
when it plunges. So if you get two or three bad
shocks then it really hurts. One bad shock you can deal with
but two or three and you run out of all assets. And then suddenly your
consumption drops massively. So you protect your consumption
for a few periods. But then if your shock continues
then suddenly you get into starvation. So that picture is actually
roughly what you find in the data, that people, at least two
years in a row, maybe they just make it. Their consumption
doesn't fall. The third year, if the rain
again falls then they go into starvation. So that's a pattern that you see
a lot, and that's exactly what you'd expect. People should try to protect
their consumption until they can by, you know, running down
assets and expect that next time income will recover. But income doesn't recover after
several times then you get hit very badly. And that's sort of what we
find also in the data. This is a pattern we also
see in the data. Another thing you can do
is try to work more. And everybody does that. You know, let's say there's a
drought and you can't farm. You go and start
to sell labor. Problem is when it's a drought,
it's a drought for everybody else. Everybody's selling labor. What happens to wages? AUDIENCE: Well, they're
much cheaper. PROFESSOR: So wages
keep going down. So in particular it could very
well be that in a drought everybody ends up trying to work
so much and wages go down so much that that amplifies
rather than reduces the risk because everybody
tries to work. So I'm going to try and go and
try and get work assuming that everybody else is not working. But when I try to go to
get work, everybody else does as well. That drives down wages to the
point where it could even be that it does nothing
to protect me. I just end up working more and
earning the same amount I would have earned otherwise. So this is something
that is this real? So there's a paper
by [INAUDIBLE] who basically looks at this. And what she does is she adds
another wrinkle to it. So she says, well, how much
you're going to do go out and look for a job versus sort
of [? desave ?]? Depends on whether you have
a bank account or not. So if you have money in your
bank account, you're less likely to go out and find an
extra job and more likely to live off your bank account or at
least partly live off your bank account. So you're going to be less
desperate to find work. That's going to drive
wages down less. So what she does is she looks
at what happens to wages in drought years versus non drought
years in areas which have good banking services
versus areas which don't have good banking services. So this is data from India. And she's comparing areas
which have good banking services versus areas that don't
have such good banking services and looking at the
effect of that on wages in drought years versus
non drought years. So in drought years wages
are going to be lower. She's asking are wages that much
lower in areas where the banking services are worse? Or alternately, are wages
relatively less likely to fall in a drought year where banking
services are better? Do you see the motivation
for that? So that's the next table. So when crop yield goes up,
which is basically rainfall-- so this is always with district
fixed effect. So we're comparing the same
district over time, the wage in the same district over time
over this period 1956 to '87. Over these 31 years we are
comparing the same district in a drought year and a
non drought year. Banking is something that
improved over time. So, in particular, if you look
in the last column, banking is also something that's
changing over time. And she's controlling
for that. And then she's asking is it
the case that where the banking is better, the effect of
a good yield in increasing wages is smaller? That's the same question as
the affect of bad yield in decreasing wages is also
going to be smaller. The effect of yield on wages,
is it smaller in districts which have better banking
services? And that negative in crop
yield interactive with banking, that negative role in
the middle says that, yes, the effect of yield on wages is
smaller where banking is better, as you'd expect. People are less desperate. They can go to the bank instead
of, you know, working. And, therefore, the
fallen wages is smaller in those places. We talked about saving. We talked about borrowing. There's a third thing
you could do. Or we talked about saving. We talked about borrowing. We talked about working. There's a fourth thing
we could do. Oops. That was dangerous. The fourth thing you could do is
you could try to do things to avoid risk. So what's an example of doing
something to avoid risk? AUDIENCE: Maybe diversify
where you're investing. PROFESSOR: Diversify where
you're investing. Give me an example. That sounds right but
general principle. Give me an example of what
you mean by diversify. AUDIENCE: Maybe, for example,
if you're a farmer, you have to [INAUDIBLE] of crops maybe. So that if some fail-- PROFESSOR: Right. So one example would be imagine
there's two crops, sugar cane and wheat. Sugar cane is much
more profitable. But wheat and sugar cane are
subject to independent risk. So when sugar cane dries up,
that doesn't affect wheat. And when wheat dries up, that
doesn't affect sugar cane. Different things affect them. Then by having a little bit of
sugar cane and a little bit of wheat, you have less risk. But, of course, you're
paying in income. You'll be taking less income
because sugar cane is more productive. So one thing people do
is they diversify. Like a very interesting paper
from many years ago showing they diversified in many,
many complex ways. One thing that was very
interesting is you'll find that in many countries,
actually, you'll find that the plots people crop are
not adjacent. And that seems to
make no sense. Why would I farm over here for
the morning, walk three kilometers over there and
farm in the afternoon? That doesn't seem to make any
sense unless you think that there are something like
micro climates. So it might rain here when
it's not raining there. Maybe when a bug attacks here,
it doesn't attack over there. So even though you're growing
the same crop, you grow it over several plots and the
plots are not contiguous. You walk from plot to plot to
avoid having exactly being in the same place. Because if you're in the same
place then the same rainfall patterns, the same bugs,
you're subject to them. If you had multiple plots in
different places, you can avoid that. Now, that's of course wasteful
because you're spending a lot of time walking, and you should
have been spending that time farming. But at least you reduce risk. So the general principle is that
you do many, many things to, like, diversify, have many
crops, many plots, many jobs. There's a study of how many
professions a family can have. And I think the maximum number
in the study was 27. They were doing 27
different things. They were small things like
going to the pond and harvesting muscles. You do that in the morning. Then you go and collect
the firewood for sale. Then your son goes and takes the
cow to the field, and your daughter feeds the chicken. So you had to add up all
those little things. But they were doing 27 different
professions. I think was the number
if I remember right. But that's basically sort of
an extreme version of this, avoiding risk by doing a little
bit of many, many, many, many, many things. That's good. It allows you to avoid risk. But it's bad because you end up
doing things which are not particularly productive. You don't do the sugar cane even
though sugar cane is much more productive than wheat. So you lose money, and
that keeps you poor. So it's estimated that it
does not weather risk. And so if you didn't change your
crop mix to deal with the risk, you would make
30% more money. So that's big. Basically the stuff that
you're doing to protect against the risk is reducing
your income by 30%. Another thing that it does is
that because you're doing so many things, you don't-- we [? are not ?] good
at any one of them. One way to get good at a
profession is by working very hard at it, learning the job. So a lot of these people, for
example, they don't want to go to the city and become a full
time worker in the city. Why? Because they think they'll
lose their job. And when they lose their job, if
they still have the farm at home, they can come back
to the farm and get a living from that. But if that means that
your job in the city is a temporary job. If I'm hiring someone temporary,
I have no incentive to give that person
any skills. I know he's going to
be gone in a month. So nobody gets start
any skills. Why? Because they're all temporary
laborers. But why are they temporary
laborers? Because they don't want to put
all their money into this one basket, all the eggs into this
one basket because they think that suppose I lose that job,
what's going to happen? I might as will keep
my foot in farming. And so they keep their
foot in farming. They keep their foot
in the city. They keep their foot in
farming sugar cane. They keep their foot
in farming wheat. They do many, many
different things. That means they don't get good
at anything, and they don't take advantage of what
they're good at. So one other thing
you could do is actually offer insurance. To all of these strategies
the logical alternative is insurance. What is insurance? What would be weather
insurance? What's an insurance? Yeah? AUDIENCE: The idea for the
insurance is to gather up a large group of people with
different specific exposures to a certain risk and then
to pool that risk. So you pay marginally in the
event that something happens, and then you get a
reimbursement. PROFESSOR: What does the
contract look like? I am asking a simple question. You're right. AUDIENCE: You pay an
annual premium. And then if something happens,
you get reimbursed for it. PROFESSOR: Right. So if the weather is really bad,
you give me $1,000, and I pay $50 in a normal
year or something. You want to say something? AUDIENCE: I mean, another
alternative to private insurance would be
to have some form of government insurance. So I was thinking when you were
talking about this that are a lot of historically sort
of much more seemingly primitive societies who did a
better job of sort of dealing with these issues, like, say,
like, the Incas or even, like, the Mycenaeans or something. And what seems to be different
is that they had kind of somewhat strong functioning
central states that redistributed across. People like the Incas didn't
even have money or sort of markets in the modern sense that
we've talked about, yet they had this sort of
sophisticated system of redistribution and, like,
collection of agricultural products to, I guess, feed
the military but also to smooth risk. PROFESSOR: Yes. So we'll talk a little bit about
that in the end, which is you're talking about,
I think, something very important which is what would
public policy look like here? You would want some way
to insure people. But right now I'm asking
a narrow question. If I was facing risk and there
was an insurance market, I could buy insurance, right? If I'm worried about risk and
I'm doing all kinds of inefficient things to avoid
risk, I could deal with it by just saying, look, you know, I'm
going to buy insurance on the weather. And when the weather's bad,
I'm going to get money. So here's a weather insurance
product in Ghana. This was offered at different
prices to different people. And the striking fact here is
when you offer at a price of zero, people are willing to
take it, not entirely surprisingly. However, as the price goes up
to an actually fair price-- what is an actually fair
price, if I can say the word correctly? Yeah? AUDIENCE: It's the amount
it actually costs, like, aggregate to get to an expected
value of zero. PROFESSOR: Right. So the amount I pay you in
expectation is equal to the amount you pay. That's actually fair price. You can see that some
people buy above the actually fair price. Why is that? AUDIENCE: [INAUDIBLE]. PROFESSOR: Sorry? AUDIENCE: [INAUDIBLE]. PROFESSOR: Because they're
risk adverse. So you're really willing
to pay the market. Economic theory would say you
should be willing to pay more than the actually fair price. Why? Because the actually fair price
says on average you break even. But risk hurts you a lot. So you don't want to break
even on average. You're willing to pay extra
money to get rid of the bad things that happen when-- risk hurts you more
than just-- it's not just that sometimes
you get more, sometimes you get less. The fact that sometimes you get
less is worrying you, is making you do bad things
that are inefficient. So you should be willing to
pay more than the actually fair price to get insurance
because that's the whole idea of insurance. Car insurance is almost hugely
not fair if you look at the car insurance we have the US. Why do we have that? Because we want to be covered
against the possibility that sometimes people will
sue us for a million dollars in damages. And so we are willing to pay a
lot more than what's fair. So these people, they're
not willing to pay. At the fair price, 30%
willing to take it. And you have to really go down
to about the price of one, that's 1/9 of the fair price,
to get people to take it. So people don't seem
to want insurance. So if everything I said
so far was true, why don't they want insurance? I said they did all these
inefficient things to deal with risk. Isn't that immediately
telling us that they should want insurance? Yes? No? And, in fact, when they take
insurance, good things happen. So this picture, what it shows,
this is spending on-- total chemical spending
is an odd title. I didn't put it there. But it's total spending on
chemical fertilizer. So how much fertilizer
do you buy? Well, when you get insurance,
you buy about, you know, a little bit more than
in control. So some people were
offered insurance. Some people were
offered credit. Some people were offered both. And you see the sum gains
in investment. People under invest
when they get-- so relative to getting
just the loan, insurance really helps. So when you get a loan, you
don't want the loan if it doesn't come with insurance
because you worry that you can't repay the loan. So you don't actually
gain much. So if you're offered the
loan, you gain nothing. But when you're offered loan
and insurance then your investment goes up by
about almost 50%. So you really invest a lot more
in fertilizer when you get insurance and credit
together relative to getting just credit. So that says that that
affects your income. This says that this affects
your welfare. When you get insurance and
credit, you are actually about half as likely to have
somebody in your family miss a meal. That's an extreme
form of risk. You're just starving because
you don't have money. That halves when you
offer insurance. So insurance is very good for
these people, whether or not they want it. Insurance seems to be
increasing output and reducing risk. AUDIENCE: Wait. Can you go back to that slide? PROFESSOR: Yeah. AUDIENCE: I don't understand. So the both is if they get
insurance and the loan? [? PROFESSOR: Bought ?]
and credit. AUDIENCE: And so then the
percentage of people missing meals of that goes down
dramatically? PROFESSOR: Dramatically, yeah. AUDIENCE: But what is it that if
they have just insurance or just capital, it looks like it
increases over the control? PROFESSOR: It doesn't
really increase. Like, as you can see, you need
both for it to work. So why aren't they insured? And there are two versions
of this question. One is why aren't they buying
insurance in the market? And the other is why aren't
they buying-- if they don't buy insurance,
they can still do something else, which is one way to get
insurance is for all of us to just pool together. The government doesn't
have to do anything. The market doesn't have
to do anything. We all live in the
same village. We can all get together, and
we can all adopt the rule which says that if any of us
loses 50% of their income, we'll all pay them
1% of our income. We could adopt that
rule, right? And that would insure everybody
because there's, like, 50 of us in this room. If I lose 50% of income, all
of you give me 1% of your incomes and I'm OK. So you can ensure me. We don't need a market
to do it. We can just do it at the
community level. AUDIENCE: [INAUDIBLE] limitation of that is the fact
that you're diversifying across a larger geographical
area or presumable, like, a bad weather condition. PROFESSOR: Absolutely. But we should at
least do that. The fact is that people seem to
have limited insurance even from their friends. AUDIENCE: But couldn't that
potentially open you up to huge exposure as
an individual? PROFESSOR: Why? AUDIENCE: I mean, I guess if
everybody gets equally then even if you have a really bad
year-- but if everybody has a bad year then you wouldn't
require it. PROFESSOR: You can adopt a
rule which basically says let's take an average income
of everybody and then those who get more than average in
that given year give a little bit to the ones who get
less than average. You can always do that. So in substance it's a puzzle. Why don't they buy it
from the market? Why don't they buy it
from each other? And there's been a lot
of hype in this area. Like, Forbes Magazine had this
issue where they said the "insurance for the poor is an
unpenetrated natural market." And a lot of microfinance
institutions have been talking about the next microcredit
revolution is micro insurance. So they're going to provide
insurance to people. But in fact we don't see very
much insurance being supplied or demanded. Now, insurance is difficult
for a variety of reasons. Does anybody know what
moral hazard is? AUDIENCE: Yeah. Moral hazard is just
the concept that-- I guess it could be best illustrated through the example. There was a huge [INAUDIBLE]
about moral hazard about bailing out the banks because
it could encourage banking institutions in the future to
act more recklessly because there's this implicit guarantee
it could backstop because it happened
once before. PROFESSOR: Right. So one problem with
insurance-- but this doesn't explain why
people don't want it. It just explains why it
could be expensive. You know, if I offer insurance
to you and I say that I'll take care of you whenever your
income falls, your incentive to stay home goes up a lot. That's moral hazard. What's adverse selection? AUDIENCE: You're only drawing
those with high risk. PROFESSOR: Yeah. The other worry is that you tend
to draw in the people. So if I offer people the option
of, you know, whenever your income falls, I'll
take care of you. I might only get the people who
they know their income is going to fall come and
join that scheme. That's adverse selection. So we have both of those. And there's outright fraud
because people might claim their income has fallen
but in fact their income hasn't fallen. How do I measure that? So it's expensive to deliver. That's a given. But nevertheless,
the reason why-- but you would imagine that at
least some forms of insurance should exist. One is catastrophic
health insurance. Like, you were in a
traffic accident. Nobody gets into a traffic
accident on purpose, very little moral hazard. Why isn't there insurance
for that at least? Another one is weather
insurance. I don't control the weather. So there's no moral hazard
or adverse selection. I don't control the weather. The weather is what it is. So if you say that, why don't
we get lots of market for rainfall insurance? When the rainfall is below some
cut off, I pay you money otherwise you pay me money. So we would at least expect to
see these kinds of insurances. It's difficult to have, like,
more complex insurance. Maybe there's some fraud
or something. But this kind of insurance,
why don't we see more of it in the world? So this is a sort of where we're
beginning to understand. So there was this huge hype,
like, five years ago, everybody in the world was
talking about how the next revolution in micro insurance. And then that revolution
kind of never happened. In fact, it was kind
of, if you like-- we worked with a micro finance organization to offer insurance. And after about a year, they
basically said, look, you guys, we can't do this. We're losing clients every day
because they were forcing their clients to
buy insurance. The way you avoid adverse
selection is by forcing people to buy it. You don't want people to have
choice otherwise only the sick people will buy health
insurance. They're forcing all
their clients to buy health insurance. As a result, all their clients
were deserting them. So they basically canceled
the program. So nobody seems to
want insurance. Now, I don't think people
have fully understood what's going on there. I certainly don't. I mean, I think part
of it is people don't understand insurance. So part of the problem is
that people think, well, I'm giving you money. And if I don't use this service,
you should give me the money back. So the idea that I'm giving
you something-- see, for most of us, the bizarre
thing about insurance is it's a product that
you really don't want to use, right? Insurance is one thing. But you want to buy
it but not use it. I'm happy when I don't get
sick and, therefore, I'm really happy when I paid for it
and I didn't get anything. Psychologically, it's an odd
product in that sense. It's a product that you're
happiest when you don't use it. So that's one problem clearly. It's a bizarre product. It's one unique kind
of product. Usually we're happy when we
get what we paid for. Here, you're happy when you
don't get what you paid for. And that makes it difficult. Second thing, I think,
is they don't trust the insurance company. And there's some evidence that
when the insurance company has come through an NGO which people
know and like, they're more willing to buy it. So there's some trust
element there. But I think there's
something else that I think is difficult. So think of catastrophic
health insurance. And if I was offering
catastrophic health insurance, our theory was very simple. Nobody gets a heart
attack on purpose. Nobody gets cancer on purpose. So let's just insure
those things. That was OK. The theory seemed to work. The problem is people also
die from other things. Like, the stomach hurts and
then they probably got an infection and died. That's not covered by the
insurance because, you know, in general it's only particular conditions that are covered. People don't understand why one
thing that is covered and another thing isn't. And if you explain that, well,
there's more moral hazard in this one than that one then
that's too hard to explain. So, basically, insurance
products, out of the necessity of protecting the insurance
organization from adverse selection and moral hazard,
tend to be incomplete. They cover only a
few conditions. People don't understand
those conditions. So there was this big fight
with this [INAUDIBLE] we worked with. They got into this big fight
with a group of women who were very upset because one of their
friend's husband died. He died at home. He suddenly got sick and died. When he got sick, she went
to the local doctor. And the local doctor recommended
a whole bunch of medication, expensive medication
which was useless because the doctor,
I think, was bad. The insurance company
said this was not a covered condition. We can't pay for it because it
was not covered in fact. The insurance company in this
particular case said we will only cover conditions that
require hospitalization, and we'll only pay if you have
been hospitalized. That's a very good way to
check whether people are making up conditions or not. So they had imposed this
hospitalization condition, which was to protect them. But then these people said,
look, her husband died. How could it be worse? You have to pay. So it was a big fight. The insurance company
refused to pay. As a result, all of them
quit [INAUDIBLE]. So just the nature of the
product is difficult. That's one final psychological
element which I think is also difficult, which is catastrophic
insurance is particularly a product
that makes you-- you value it when you think
about your own death or something or something
really bad. People don't like thinking
about those things. So it's very hard to get people
to be rational about buying a product that involves
contemplating really awful things happening to you. So a lot of people are both, I
think, maybe they are a little bit superstitious about it. So they don't really like taking
on this risk, thinking about these states of awful
things happening. So if you're going to insure us
to insure awful things like when the crop completely dries
up, that's not what people want to think about. So that's another reason why. But in general, we don't fully
understand why people aren't buying these products. But they aren't buying them. So if there's no question,
I'll stop here. [INAUDIBLE].
