Pretentious title aside, this is both an important theoretical point and also a practical way to make development interventions more effective. This point is developed further in an upcoming working paper but for those of you who want a quick precis, the arguments are summarised here.
Homo Economicus is the caricatured perfectly economically rational individual on which most economic theory is based. When acting as a producer (including through labour) they will aim to maximise returns and when playing the role of consumer, they will aim to get maximum utility for from their investment i.e. the best value for money. Behavioural economics has done a fairly comprehensive job of picking apart the assumption of rationality by revealing the other factors that dictate behaviour. In fact, behavioural economics has not so much ‘debunked’ rationality, but rather elaborated rationality as a more pluralistic phenomenon and provided evidence for it. This should not have been particularly revelatory. If you look at your own life, even if you consider your work to be a primarily economic transaction, if someone offered you a 1% pay rise to change jobs, evidence says that very few of you would do it. Social bonds with colleagues, trust, fear of the unknown, time, power, and status might all have a role to play amongst many other factors. There are also intrinsic motivations which no one has quite managed to explain; why people follow footprints drawn on the floor at the expense of taking a shortcut when no one is watching and there are no consequences to not following the footprints? Whether these are revealed or hidden motivations, behaviour is dictated by a wide range of factors.
When it comes to firms, however, the overwhelming majority of theory and practice tends to consider the actions of firms as perfectly economically rational; Firmo Economicus. This is in itself, demonstrably irrational. Firms are run by people and their decisions are made by people, individually or collaboratively. If the homo economicus that doesn’t exist as an individual enters a firm, do they suddenly become rational? The ‘objectivity’ of the decision making of firms is greatly overstated and in understanding and attempting to change the behaviour of firms, it is important to understand the factors that drive the behaviour of the individuals that make the decisions within that firm.
In the majority of cases, firms are not profit maximising, even when they think they are. A business owner could increase net profits by not contracting out the cleaning and doing it in their spare time, but incentives such as minimising toil, social status, and quality of life play a key role in this seemingly minor decision. Economic theory might explain this away as allocative efficiency by looking at this as an efficient distribution of resources as a business owner might in reality earn more from allowing a cleaner to specialise in their profession while spending their own time earning money at a higher rate. In reality however, this is neither a conscious nor subconscious calculation. The real drivers of behaviour are much more complex and go way beyond maximising economic returns.
An important dynamic to consider here is that move from stakeholder to shareholder capitalism that comes with economic development. In developing economies, stakeholder capitalism dominates. Businesses are dominated by owner operators and, where they are not, the distance between the decision makers in a firm and its investors is small, with family and friends playing a key role in investing. As economies grow, and private equity increases, the influence of investors as decision makers increases and investors, by and large, have financial incentives as their major driver. Accountability structures for firm decision makers are built around these incentives. At the extreme end, the share price of listed companies is in some cases seen as the only measure of performance and all decisions taken are designed to increase it.
So what? A systemic approach attempts to work with existing actors within a system and change their behaviour where the cumulative result is beneficial to a disadvantaged group. To do this is it essential when a given organisation, be they public or private, has a role to play in delivering this outcome, that their behaviours are analysed as the product of the individuals that make up the organisation. In selecting partners and trying to influence behaviours, don’t just think of whether an organisation is public or private but of the complex incentives that drive their decision making.