BEHAVIORAL ECONOMICS AND
ENVIRONMENT
L. Venkatachalam
DISSEMINATION PAPER - 30
Centre of Excellence in Environmental Economics
(Sponsored by Ministry of Environment and Forests, Government of India)
MADRAS SCHOOL OF ECONOMICS
SEPTEMBER 2014
DISSEMINATION PAPER SERIES
The Centre of Excellence in Environmental Economics was asked by the Ministry of
Environment and Forests to explain the concepts of environmental economics to noneconomists through a series of short dissemination papers. The authors welcome feedback on
the papers from readers. The following Thirty dissemination papers have been posted on the
Centre Website (http://coe.mse.ac.in).
No.
Title
Author
1. Environmental Externalities
Dr.U.Sankar
2. Vehicular Pollution Control
Dr.Vinish Kathuria
3. Environmental Accounting
Dr.G.S.Haripriya
4. Public Disclosures Using Information
to reduce pollution
Dr. Vinish Kathuria
5. Hedonic price method A Concept Note
Dr. Haripriya Gundimeda
6. Contingent Valuation Method
Dr. Haripriya Gundimeda
7. Environmental Health
Dr. Zareena Begum I
8. Precautionary Principle
Dr. K.S. Kavi Kumar
9. Ecosystem Services - A concept note
Dr. Vinish Kathuria
10. Climate Change and Adaptation
Dr. K.S. Kavi Kumar
11. Social Discount Rate, Intergenerational
Equity and Climate Change
Dr. U.Sankar
12. Plastics and Environment
Dr. Zareena Begum I
13. Clean Development Mechanism
Dr. K.S.Kavi Kumar
14. Sustainable Development
Dr. K.S.Kavi Kumar
15. Cost Benefit Analysis and Environment
Dr. K.S.Kavi Kumar
16. Carbon Trading
Dr. K.S.Kavi Kumar
17. Ecological Footprint
Dr. Ramprasad Sengupta
18. Choice Experiments
Dr. Sukanya Das
19. Solid Waste Management
Dr. Zareena Begum I
20. Common Property Resources and
Collective Action A Short Review
Pranab Mukhopadhyay
21. Green Economy
Dr. K.S. Kavi Kumar
22. Economics of Natural Resources
Rabindra N. Bhattacharya
23. Travel Cost Method For Environmental
Valuation
Dr. Sukanya Das
24. Trade and Environment
Badri Narayanan
25. Environment and Development
Dr. K.S. Kavi Kumar
26. The Economics of Biodiversity
Suneetha M S
27. Value of Statistical Life
Dr. K.R. Shanmugam
28. Energy, Economy and Environment Models Dr. K.S. Kavi Kumar
29. Choice Of Policy Instruments
– Concept Note
Vinish Kathuria
30. Behavioral Economics and Environment
L. Venkatachalam
Hard copies may be obtained from:
Member-Secretary
Centre of Excellence in Environmental Economics
Madras School of Economics
Gandhi Mandapam Road, Chennai 600 025
Email : [email protected]
Use of any part of this publication should be duly acknowledged
BEHAVIORAL ECONOMICS AND
ENVIRONMENT
L. Venkatachalam
Associate Professor
Madras Institute of Development Studies (MIDS)
[email protected]
DISSEMINATION PAPER – 30
September 2014
Center of Excellence in Environmental Economics
(Sponsored by Ministry of Environment and Forests, Government of India)
Madras School of Economics
1
2
BEHAVIORAL ECONOMICS AND ENVIRONMENT
Introduction
Lionel Robbins defined economics as ‘the science which studies human
behavior as a relationship between ends and scarce means which have
alternative uses’ (Robbins, 1945). Economics is about human behavior; it deals
with how individuals allocate their scarce resources across different needs in a
most efficient manner (called, Pareto efficiency1) in order to achieve certain
‘purposeful’ economic goals. In a perfectly competitive market economy,
efficient resource allocation is guided by the price mechanism. In reality, a
perfectly competitive market economy is an ideal situation which does not
exist. The existing markets in economies around the world are imperfect,
incomplete or defective. An imperfect market is characterized by asymmetric
information (e.g., in a health insurance market, less than optimum level of
insurance premium will be sold if the buyer of the premium has more
information about her own health than the seller of the premium has); an
incomplete market does not optimally allocate ‘public goods’ (e.g.,
groundwater as a local public good is over-exploited either due to marketimperfection or due to non-existence of market); and, a defective market does
not adequately capture externalities and their impacts (e.g., price of a polluting
commodity does not reflect the damage cost or a market does not exist for
compensating the pollution victims). So, market signals may misguide or
miserably fail the society in efficiently allocating their scarce resources. In
response, the government plays a critical role in addressing ‘market failure’
and guiding resource allocation to improve individual and social welfare. In
this regard, the governments formulate development policies that purport to
change human behavior in the right direction - through appropriate incentives
(to encourage good behavior) and disincentives (to discourage unwanted
behavior). Government policies are guided by certain schools of thought in
economics. One such dominant school of thought governing the current polices
1
Pareto efficiency or optimality is a state of resource allocation in which it is impossible to make any
one individual better- off without making at least one individual worse-off.
1
is called, ‘neoclassical economics’2 (or, mainstream economics). Neoclassical
economics, which favours market capitalism, free trade and individual liberty,
has been built on certain fundamental assumptions about human behavior.
More precisely, in order for the policies to produce efficient outcomes the
policymakers in their mind expect the economic agents to behave in a
‘consistent’ manner as established within the neoclassical economics. In the
following section, we will discuss some of the behavioral assumptions that are
relevant for the present paper.
1.
Mainstream economists take a firm position that in any economic analysis
it is the ‘individuals matter the most’ (a methodology called,
‘methodological individualism’) and the individuals are assumed to be
‘rational’ in pursuing their economic goals. Rationality in economics is
defined in terms of certain ‘axioms of preferences’. For example,
transitivity axiom suggests that if for an individual coffee is ‘as at least as
preferred as’ tea and tea is ‘as at least as preferred as’ boost, then it must
be that coffee is ‘as at least as preferred as’ boost for that individual.
There are other axioms such as, completeness, reflexive and continuous.
A simpler example of rationality goes as follows: a 16 GB pen drive is
sold for Rs. 500.00 in shop A. Shop B offers TWO units of the same 16
GB pen drive for Rs. 750.00. If the consumer’s maximum willingness to
pay for one unit of 16 GB pen drive is either equal to or above Rs.
750.00, then the consumer must purchase pen drives only from shop B.
What is going on here is that a rational consumer would be expected to
prefer ‘more’ to ‘less’ for a given budget constraint. In order for the
economic agents to be rational, they are expected to behave consistently
in accordance with various axioms of preferences.
2.
What happens if the behavior does not adhere to axioms of preferences?
In such cases, the behavior is considered to be ‘inconsistent’ and
‘irrational’, and such behavior is expected to result in sub-optimal
outcome. For a neoclassical economist, however, irrational behavior is
not a serious issue for the following reasons: a) In a nearly perfect market
2
Paul Samuelson integrated general equilibrium-based microeconomics with Keynesian
macroeconomics and called it ‘neoclassical economics’.
2
economy, irrationals are expected to correct their mistakes and resume to
rational behavior; otherwise, the market institutions would punish them.
Irrationality is expected to vanish in repeated interaction in the market
(List, 2003); b) Mistakes committed by the irrationals do not matter at the
aggregate level because, those mistakes will be appropriately capitalized
by the ‘super rational individuals’ (i.e., one person’s loss becomes
another person’s gain) and therefore, under the ceteris paribus condition
an aggregate outcome in an economy consisting of irrational economic
agents does not significantly differ from that of another economy
consisting of mostly rational agents (see Fehr and Tyran, 2005); to put it
slightly differently, if an economy consists of a large number of
irrationals, a small number of super rational agents could fix those
mistakes appropriately so that the final outcome is Pareto superior; and d)
irrational individuals in a real world economy constitute so small a
number that one can simply ignore them while analyzing economic
phenomena.
3.
A rational economic agent is assumed to capitalize all available
opportunities to maximize her utility or profit, as suggested by ‘big-bills
theory’. The following illustration explains the theory: two professors of
economics – a senior and a junior –were walking on a crowded pavement.
The junior professor found a ‘big-bill’ (a higher denomination currency
note-say, a 100 Re. note) on the pavement and rushed to collect it. The
senior professor stopped him saying that if it were a ‘real currency’, it
would have already been collected by somebody else. So, the rational
agents do not drop any big-bills on the pavement –meaning, they do not
let others benefited from a profitable venture-and even if they do so, the
bills are collected immediately by others (see Olson, 1996).
4.
Another standard assumption is that a rational human being is
‘exclusively self-interested’ (Fehr and Gachter, 2000) and she prefers to
maximize her own utility. This does not mean that she will not devote
scarce resources to improve others’ welfare. She would do so only if such
kind of act increases her own utility (e.g., an individual helping a beggar
with some money does so because doing so enhances her utility; an
3
individual would risk her life to put down the fire on her neighbour’s
house only if she believes (bit strongly) that the neighbor would
reciprocate in case her own house comes under fire in future; and so on)
(see Gintis, 2013).
5.
The economic agent is assumed to collect ‘all available information’ and
process that information in such a way as to reach a most efficient
decision and no other decision is superior to the one that the individual
has already reached. She has unlimited cognitive abilities and acts as a
computer in processing the information to reach such a decision. If at all
there is a sub-optimal decision, it can be attributed mainly to lack of
information, and not to lack of intelligence or cognitive abilities. This is
akin to say, rocket-launching where once adequate fuel (information) is
filled in the rocket it will automatically reach the exact destination
(economic goal).
Alternative Theories of Behavior: Bounded Rationality
Most of the current environmental policies that are directed towards
protecting the environment and ecosystems in economies around the world are
based on the prescriptions of the mainstream economics which is built mainly
on the above assumptions. Conventionally, environmental issues (such as,
pollution) are assumed to be caused by market failure, government failure and
institutional failure. Standard policy prescriptions for correcting market failure
such as, taxing negative externalities (Pigou, 1930), assigning well-defined
property rights (Coase, 1960), implementing second-best solution (Baumol and
Oates, 1988) and providing incentives for the community to manage
environmental resources locally
(see Venkatachalam, 2011) had not
adequately addressed the cotemporary environmental problems in any effective
manner; indeed, damage cost arising from depletion and degradation of
environment has been steadily increasing in countries like India (Mani et al.,
2012). Emerging environmental challenges - such as, climate change - pose
serious threats to human welfare. All the above issues warrant for a re-look at
the root-cause of the problem - namely, the human behavior.
In recent decades, the neoclassical assumptions pertaining especially to
human behavior are being contested by a group of researchers who call
4
themselves as ‘behavioral economists’. Indeed, the positivist approach
(prescribing more objective and fact-based measurement of events) adopted
dominantly in the analytical foundation of mainstream economics insists that
the underlying assumptions should NOT be criticized as long as the relevant
economic theory pillared by these assumptions could make valid predictions.
The behavioral economists, on the other hand, have identified certain
‘anomalies’ in human behavior – i.e., the ‘actual behavior’ observed in
empirical world is found to differ significantly from the ‘assumed behavior’ of
the neoclassical man. The point is that the behavioral anomalies are found to
weaken the predictive power of the established economic theories and
therefore, the behavioral economists have carved out alternative theories with
more realistic assumptions in analyzing human behavior.
Innumerable contingent valuation surveys3 and experimental studies (both
laboratory and field experiments) in different empirical contexts have
demonstrated that the economic agent in real world behaves in a ‘boundedly
rational’ manner. Bounded rationality constitutes the analytical foundation of
behavioral economics. Though it has not yet been precisely defined, bounded
rationality represents several ideas (Selten, 1999). For example, it gives more
emphasize on the ‘process’ by which a decision is arrived at by the human
beings, rather than merely looking at decision outcome alone. Unlike the
neoclassical human being who possesses unlimited cognitive abilities, the
human beings in behavioral economics have limited cognitive abilities and
their decision outcome depends on two aspects: the cognitive constraints
(internal to the decision-maker) and the decision environment (external factors
influencing the decision-making –such as, one’s own culture). Bounded
rationality does not altogether reject the full rationality (also called, unbounded
rationality or instrumental rationality) of economic agents; indeed, it admits
that in certain cases, the agents behave in a fully rational manner. It differs
only in arguing that when faced with a greater uncertainty, the agents utilize
‘rule of thumb’ and ‘heuristics’ to reach important decisions–an act which is
not considered as fully rational in the neoclassical economics point of view.
3
A questionnaire –based survey, widely deployed among individuals and households to elicit their
preferences towards non-marker environmental goods and services (see Carson, 2011).
5
In the following section, we are exploring the implications of bounded
rationality and various anomalies identified in behavioral economics on the
outcomes of environmental policies.
Behavioral economics provides
alternative theories of human behavior that could help us understanding
especially the policy failure in environmental sector in a better manner and
make these policies more effective by way of ‘behaviorally’ correcting them
accordingly.
Targeting or Satisficing
Bounded rationality suggests that individuals do not always maximize
their utility or profit; rather, they are ‘targeting’ or ‘satisficing’’ – i.e., they set
a ‘target’ (of say, income to be earned) and try to achieve that target by using
their ‘limited amount’ of cognitive abilities within a given external
environment; once they achieve the initial target, they fix a higher level of
target and try achieving it; in case they fail in the first instance, they set a
lower, achievable target and get ‘satisfied’ with the outcome. Targeting can be
explained with a following example: In New York city, the cab drivers hire the
cabs from the owners and in turn they pay the owners a fixed price as rent- US
$ 76 for a day shift and US$86 for a night shift. Any earnings over and above
the rent become the income of the drivers. It was found that the drivers exhibit
a particular behavioral pattern: on a busy day where there is more demand for
cab service, the drivers withdraw earlier and call it a day; on a dry day where
the demand is lesser, the drivers work for longer hours. The drivers’ behavior
is just contrary to what the mainstream economic theory would predict: on a
busy day, they should work for longer hours and maximize their profit as much
as possible (because, ‘big-bills’ are waiting to be picked up) and on a dry day
where the demand is low (big-bills are scarce), they have to withdraw early and
go home (Camerer, et al., 2000). What is going on here is that the drivers are
found to fix a ‘target’ level of income and work towards earning that level of
income - on a busy day, they can earn it quickly and on a dry day, they have to
spend more time.
What is the implication of targeting on environmental policy? It suggests
that the environmental policymakers have to first understand what is the nature
of the economic goal that users of the environmental resource being governed
6
by the policy do adopt -is it targeting or maximizing? This is where scientific
inputs from behavioral research, for example, would assist the policymakers.
Targeting has implications for tragedy of the commons problem which requires
behavioral change among the users. First of all, understanding what is being
‘targeted’ by the users is important. When the ‘targeting’ is an objective of
significant number of individuals in an economy, adopting an environmental
policy with ‘maximizing’ assumption would crowd out the environmentally
benign behavior –sometimes, leading to over-exploitation of resources. If users
are targeting a particular level of material well-being by way of exploiting the
environment, an external intervention to change such behavior becomes
imminent. For instance, the economically powerful fishermen, in order to
increase their individual material wealth in the short-run, would compete with
each other to deploy sophisticated fishing technologies that may erode the fish
stock in the sea. Here, government’s intervention to ban that technology would
prevent vanishing fish stock. If, on the other hand, the target level of
consumption of ecosystem services falls below the carrying capacity of the
environment, then tragedy of commons problem may not occur; here an
external intervention should be as minimum as possible –i.e., intervention only
when extraction rate exceeds the carrying capacity. Let us take the lifestyle of
Irula community in a village where I lived during my childhood period. I found
members of this community used to go to a nearby mangrove forests to catch
fish, crabs and tortoise, sufficient only for subsistence consumption. If most of
the users of environment behave like the Irulas, government intervention with
stringent environmental measures (such as, preventing their entry into the
mangroves) would deteriorate their welfare since their target level of
consumption is equivalent only to subsistence level. On the other hand,
stringent measures would improve the quality of the environment if the target
level is set above the carrying capacity which would result in over-exploitation.
For example, imposing a curb on groundwater over-exploitation in dark zones
(where the recharge rate is much lower than the extraction rate) would benefit
the groundwater users on a sustainable basis.
What targets do the governments want to pursue does also matter for
effective environmental policies. The modern governments as welfare states
have fixed certain standard economic targets to be achieved. Most of them aim
7
at setting a target level of per capita gross domestic product (GDP) and
formulate economic policies towards achieving it. Most of these policies are
based on the Environmental Kuznets Curve (EKC) hypothesis. The EKC
hypothesis suggests that during initial years of economic development, the
developing countries should focus more on enhancing per capita GDP so that
poverty and inequality can be reduced with increasing income; protecting
environment is economically unimportant during this period because, doing so
would adversely affect income growth (e.g., pollution control requires transfer
of resource which otherwise be used for producing industrial output). At a low
level of development, environmental quality is considered a luxury good;
income elasticity of demand for it is very high. Thus, economic development at
the cost of environment is acceptable. Nevertheless, many empirical studies
have categorically demonstrated that protecting the environment right from
initial level of economic development and improving the supply of
environmental amenities - such as, water supply and sanitation - to the poorer
sections of the society would significantly increase the per capita income and
social welfare (see Dasgupta, 2001). So, policies targeting a higher level of
environmental quality rather than per capita income alone can generate a
substantial amount of big-bills in the economy on a sustainable basis.
Hyperbolic Discounting
In conventional cost-benefit analysis, discount rate used is exponential in
nature. The exponential discount rate is constant across the period of life
expectancy of the project under consideration. The reason is that mainstream
economists assume that time preference of the individuals is stable across time
period (i.e., behavior is time consistent). It means ‘a person's relative
preference for well-being at any earlier date over a later date is the same no
matter when she is asked’ (O'Donogue and Rabin, 1999: 103). Many empirical
studies, however, found that individuals use ‘hyperbolic discounting’ – that is,
a higher level of discount rate is used for a benefit that occurs in immediate
future and a lower discount rate to the same benefit that occurs in a distant
future. In an experimental study, individuals faced with the option of having
$100 today and $105 tomorrow selected $100 today rather than $105 just one
day later. But, in another option where $100 occurs in the 100th day and $105
8
occurs in the 101st day from now they preferred $105 on the 101st day. On top,
when the individuals approach the distant future, they reverse their preference
by way of using a higher level of discount rate –i.e., when they approach 100th
day they prefer $ 100, rather than $105 on 101st day. If individuals are
impatient and present-biased, they would target a higher level of consumption
in case the benefit occurs right now. In the environment domain, such behavior
may lead to over-exploitation. A lower level of consumption target for a
benefit that would occur in the distant future would obviously lead to
conservation of environment. However, when they approach the future time
period they reverse their initial preference and adjust their discount rate
upwards - resulting in possible over-exploitation. The preference reversal that
occurs due to self-control problem4 among individuals implies that the intertemporal benefits and costs estimated ex-ante for environmental projects are
subject to change when we move on the time horizon. This implies that social
benefits and costs elicited (through contingent valuation studies) for
improvements/reductions in environmental amenities at present are subject to
change in future. Therefore, a decision (e.g., construction of an irrigation
multi-purpose dam) taken on the basis of stable preference cannot be reversed
when the preference reversal takes place in future. In other words, a project
that passes cost-benefit test at present may become non-viable when we move
on the time scale.
Incentives and Disincentives
In order to address environmental externalities-such as, pollutioncountries around the world are moving away from pollution control policies,
dominated by the conventional command-and-control methods, towards
policies that incorporate more of market-based instruments (MBIs). The MBIs
include Pigouvian prescriptions: a ‘subsidy’ to encourage activities that
generate positive environmental externalities (e.g., activities that absorb carbon
in the atmosphere) and a tax to discourage activities that generate negative
externalities (e.g., industrial activities causing water pollution). In the case of
4
An individual is said to have self-control problem when she has a self-conflict over consumption of
say, a particular good. For example, many smokers take an oath to give up smoking on 31st
December - every year! They desperately want to give up smoking but could not do so.
9
pollution tax, Pigou suggested that a tax will have to be imposed on the unit of
effluents and an optimum pollution control is achieved when the tax is imposed
at that point where the marginal social benefit is equivalent to the marginal
social cost. However, the Pigouvian tax may not produce a predicted outcome
of optimal level of pollution control if the polluter’s actual behavior is different
from the expected behavior. This may be illustrated with the results from an
actual field experiment in a different context (Gneezy and Rustichini, 2000a).
In some of the day-care centers in Israel, few parents come late to pick up their
children after school hours. Such behavior imposed real cost on the school
administration since it has to pay extra amount to the staff taking care of the
children picked up after school hours. In order to discourage the parents who
practice late pick-up, an experiment was conducted where half of the day-care
centers introduced a fine of US $ 2.7 on those parents who arrived 10 minutes
late. Contrary to the conventional expectation, imposing fine indeed increased
the late-pick up significantly–almost twice as large as the initial late pick up.
When the fine was removed after some weeks, the late pick up that reached a
higher level of equilibrium remained stable. What is its implication on
pollution control? If the size of the pollution tax is small (from the polluter’s
point of view) then the polluter would rather prefer to pay the tax than reducing
pollution through cost effective methods. The social cost of pollution may
continue to prevail in the economy, despite a Pigouvian tax.
Individuals have some moral obligations, rather than strictly following
economic principles. Many individuals donate blood without expecting any
reward. Experimental results suggest that when the voluntary blood donors
were given money for their service, they stopped donating blood. A moral
responsibility of the individual disappears when a financial incentive or disincentive is introduced (Gneezy and Rustichini, 2000b). Increased late pick up
after the fine suggests that those parents who believe picking up their children
on time as their ‘moral obligation’ do no longer believe so. This means that if
the polluters have moral obligations to control pollution irrespective of a
market- intervention, imposing market institution may erode already prevailing
good behavior and pave way of sustaining the detrimental effects of continuous
polluting activities.
10
Endowment Effect
In conventional microeconomics, the indifference curve analysis suggests
that for any two points along the indifference curve the ratio of the exchange
between the two commodities is constant –i.e., if a consumer prefers to buy
two more apples, she may have to give up four oranges; if she buys four more
oranges, then she may have to give up two apples. Endowment effect, which is
identified as a behavioral anomaly, suggests that once the apples become the
endowment of the consumer then the consumer would prefer more than four
oranges for giving up those two apples or would give up less than two apples
for obtaining four oranges (the marginal rate of substitution (MRS) of giving
up apples to oranges becomes lesser at that point); sometimes, the consumer
may not be willing to give up the apples at all for any amount of oranges
offered to her (the MRS becomes zero). In other words, the subjective value
placed on the two apples that already became her endowment becomes
significantly higher than the value she would place before they become part of
her endowment. More precisely, the marginal willingness to accept
compensation (WTAC) for giving up those two apples from her endowment
becomes greater than the marginal willingness to pay (WTP) for purchasing
those two apples. Loss aversion5 explains the existence of endowment effect
(Kahneman, et al., 1991)6. Endowment effect has a bearing on environmental
5
A tendency charecterised by a strong preference to avoid loss of something than to gain the same
thing. For example, increasing the initially fixed salary of an individual from Rs. 60,000 to Rs. 80,000
(a gain of Rs. 20,000) per month or reducing her initially fixed salary of Rs.1,00,000 to Rs. 80,000 (a
loss of Rs. 20,000) per month. The individual exhibiting loss aversion would have stronger preference
to avoid the latter than preferring the former.
6
There are neoclassical explanations for the WTP and WTA disparity: a) income effect may play a
role in explaining the disparity. For example, if the price of the good under consideration is high then
WTP for additional units would be constrained by income (therefore, the WTP becomes smaller); if the
good is already in possession of the consumer, then her WTA value would be larger since the market
price of it is also high (or value of the utility lost is high) (see Willig, 1976); a slightly different
explanation comes from Zhao and Kling (2011) who argue that if a consumer is not in a hurry to buy
the good her WTP will be minimum (because she wants to wait for some more time) and if she has no
urge to sell the good right now and use the money on some other products, her WTA value for selling
the good now will be high; b) substitution effect (Hanemann, 1991) suggests that if the good under
consideration has more private goods as substitutes, then the WTP and WTA will not differ much; the
lesser the number of substitutes, the more is the disparity between WTP and WTA; c) transaction cost
11
policy. Nowadays, many countries utilize tradable pollution permits –an MBI for controlling pollution at a least cost. If endowment effect exists, then firms
who have already bought the permits will not be willing to sell those permits
even if the transaction cost of trading the permits is insignificant (see
Kahneman et al., 1990). Similarly, with the endowment effect an old
technology that is polluting more may not be easily replaced with the new,
less-polluting technology.
Perception and Behavior
Individuals tend to overestimate small probability events that are more
intense in terms of their impact (called, ‘tail events’; see Barberis, 2013),
especially before they experienced the impacts. For example, highly intensive
cyclones occur less frequently but, their impacts are devastating; tsunamis
seldom occur but their economic and social impacts are destructive in nature.
Though the frequency of these events is low, individuals usually assign high
probability to the occurrence of these events. For example, the highly intensive
tropical cyclone called, Thane that hit the coastal areas of Tamil Nadu in 2011
had caused a significant level of long-term economic damage. Even though
information about the movement of the cyclone, its intensity and its possible
destination has been constantly communicated to people living on its path well
in advance, media reports revealed that the households in the affected villages
did not take necessary steps such as, storing adequate fuel-wood and water that
would have reduced ghastly impacts on the households. Informal discussion
with the affected people after that cyclone disclosed the fact that they did not
take the information about that cyclone very seriously; they indeed seem to
have believed that the ensuing cyclone would be just like the preceding ones
that were less intensive in nature. This implies that they underreacted until they
experienced its impact. After their terrible experience with Thane cyclone, the
households were found to ‘over-react’ to the information about any subsequent
cyclone that occurred with very low intensity. Both ‘underreacting’ and
‘overreacting’ impose a larger marginal social cost which would otherwise be
(TC) explanation is that if the transaction cost of buying the good is high, then the WTP (net of TC) will
be low and the WTA compensation will be high (because it includes the TC incurred).
12
optimal under the ‘normal behavior’. When individual’s actual behavior is
different than expected, changing their behavior in a desired manner can be
effected by changing the way in which the information is communicated to
them. For example, in Bangladesh a cyclone with an actual intensity of 5 (low
intensity) will be declared as having intensity of 7 (high intensity) so that the
fishermen will take the forthcoming cyclone seriously and will not venture into
the sea for fishing and get killed (Enamul Haque, personal communication).
In Gurgaon near Delhi, half of the randomly selected households in the
sample were told that their drinking water was contaminated with fecal
materials and these households started changing their water use behavior
immediately (i.e., by boiling water, etc) and the willingness to pay for
improved water quality measured in terms of ‘defensive expenditure’ was
found to be significant (Somanathan and Jalan, 2008). The results of the above
experiment indicate that the conventional belief is that water from the public
sources is already pure. Such perception imposes a significant amount of
social cost in the form of health damage. The normative implication is that the
government has the sole responsibility of supplying purified water to the
households. Though informing the households about water quality may change
their behavior in a desirable manner, the cost of purifying urban water at a
more decentralized level is much higher compared to centralized purification
by the government.
Reciprocal Behavior
As we have already seen, mainstream economics assumes that rational
individuals would capitalize all available opportunities to ‘maximize’ their
utility- even if it is a penny which could help them in achieving such goal. In
many of the ‘ultimatum game’ experiments7, researchers have found that the
respondents have categorically rejected ‘offers’ (made by ‘proposers’) that are
less than 30% of the total amount being shared in such a way that neither the
proposer nor the respondent gets any pay off at all. This is just contrary to the
7
In an ‘ultimatum game’ experiment, for example, an economic agent (called ‘the proposer’) is
supposed to share some amount of money with another economic agent who is a ‘stranger’ (called
‘the respondent’). The rule of the game is that if the respondent accepts the ‘offer’ of the proposer,
then the money is shared accordingly between the two; if the respondent rejects the offer, then both of
them will get nothing (see Camerer et al. 2004).
13
prediction of the mainstream economics. So, punishment becomes the
dominant strategy in case the deal is ‘unfair’. This implies that individuals are
willing to sacrifice their own material pay off to punish violators. In the case of
‘dictator game’8, it was found that many ‘proposers’ have indeed shared up to
20% of their pay-off, suggesting that individuals adopt ‘other-regarding’
preferences as well (Camerer, 1997). The point is, the economic agents are not
‘exclusively self-interested’. Findings of field experiments in cross-cultural
contexts have provided support to reciprocal behavior than to conventionally
assumed behavior in mainstream economics (e.g., Henrich et al., 2001). What
implications does the reciprocal behavior have on environmental policy? Many
environmental goods and services are public goods in nature and policies on
providing these goods aim mainly at bringing ‘collective action’ among agents
so that these goods can be provided efficiently. Other-regarding preference
implies that tragedy of commons problem may not be a dominant outcome
since users are willing to sacrifice their own welfare in order to improve
other’s welfare as well. This suggests that the locally existing norms can
significantly contribute to the distribution of environmental benefits across the
stakeholders, even without external intervention. Hardin (1968) argued that
behavior of self-interested, maximizing individuals will lead to overexploitation of the commons, leading ultimately to self-destruction; therefore, a
third party (mainly, the government) intervention is warranted for avoiding
such self-destruction. Olson (1971) argued that self-interested rational
individuals tend to ‘free ride’ and collective action required for optimal
provision of public goods will not emerge even with government intervention.
Since governments also fail, Olson (1971) was in favour of small groups that
could monitor free-riders more effectively and nurture market-like competition
to manage environmental goods. Ostrom (1998) empirically demonstrated that
it is neither government nor market but the communities themselves could
successfully manage environmental public goods for centuries together, mostly
with their own local norms such as, ‘reciprocal behavior’. The implication is
that the ‘self-enforced rules’, like punishments, become the dominant strategy
of the individuals and environmental policies incorporating reciprocal behavior
In a dictator game, the respondent accepts the offer from the proposer and even if the respondent
rejects the offer, it will not affect the proposer’s pay-off.
8
14
will bring in collective action to minimize the ‘free-riding’ behavior as well as
the damage cost associated with that, and would result in efficient, equitable
and sustainable provision of environmental goods.
Way-Forward
Conventionally, environmental problems were attributed to ‘market
failure’ (Pigou, 1930). Later on, it was attributed to government failure (Maler
and Munasinghe, 1996). Then, the literature on environmental management
suggested that all institutions (government, markets, communities, etc) are
responsible for the current environmental problems. Behavioral economics –
especially the bounded rationality school - suggests that the root-cause of all
failures is due to ‘individual failure’. The behavioral economists argue that
‘individual failure’ can be corrected by a paternalistic intervention (usually, by
the government); some behavioral economists prescribe ‘paternalism’ such as,
‘libertarian paternalism’- which advocates only policies that help the irrational
without limiting freedom at all (Thaler and Sunstein, 2008) and ‘asymmetric
paternalism’ - which promotes only policies that help the irrational a great deal
while limiting freedom only a little (Camerer et al., 2003). The prescriptions
ignore the fact that the government is also run by ‘boundedly rational’
individuals (Bendor, 2010) and therefore, government may also commit
mistakes. Also, all environmental measures are formulated in an information
uncertain environment. That is, the government agencies protecting the
environment, the scientists providing inputs for policymaking and the
individuals–both the users and victims-all are boundedly rational. All of us
agree that our existing knowledge about environment and how human beings
behave in relation to environment is inadequate. Therefore, formulating future
environmental policies will have to recognize bounded rationality scattered in
the economy and act accordingly by way of creating appropriate institutions
and organisations in order to redirect the economies towards sustainable
development.
15
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19
Centre of Excellence in Environmental Economics
The Ministry of Environment and Forest, Government of India has
designated Madras School of Economics as a Centre of Excellence in the
area of Environmental Economics. The Centre carries out research work
on: Development of Economic Instruments, Trade and Environment, and
Cost-Benefit Analysis. The Centre is primarily engaged in research
projects, training programme and providing policy assistance to the
Ministry on various topics. The Centre is also responsible for the
development and maintenance of a website (http://coe.mse.ac.in), and for
the dissemination of concept papers on Environmental Economics.
Madras School of Economics
Madras School of Economics was founded in 1993 as a private postgraduate institution for teaching and research in economics. MSE offers a
two-year Master's program in Economics, Financial Economics, Applied
Quantitative Finance, Actuarial Economics and Environmental Economics
affiliated to the Central University of Tamil Nadu, and a Ph.D. programme
affiliated to Madras University. MSE has undertaken a large number of
research projects since its inception, including the World Bank sponsored
Capacity Building Programme in Environmental Economics. The World
Bank project involved research, training, curriculum, and overseas
fellowship components which were coordinated by MSE. Subsequently, the
Ministry of Environment and Forests approved the proposal to set up a
Centre of Excellence in Environmental Economics at MSE. MSE has also
served as an ENVIS Centre in Environmental Economics under the
Environment Information System (ENVIS) of the Ministry of Environment
and Forests, Government of India. A dedicated program on Trade and
Environment, with support from the Ministry of Environment and Forests,
Government of India, has been initiated at MSE.
Centre of Excellence in Environmental Economics
Madras School of Economics
Gandhi Mandapam Road
Chennai - 600 025
Ph: 2235 2157/2230 0304/2230 0307
Fax: 2235 4847/2235 2155
Email: [email protected]
Web: http://coe.mse.ac.in