There is an anomaly in the economic literature called the “flypaper effect” that can be leveraged to help poor people make better investments. To understand what this phenomenon is, consider the food stamp program of the U.S. government. Food stamps are an example of what economists call “in-kind” grants. Basically, it is money that can only be spent on a specific good. When the government gives out food stamps to poor people, it expects that they will now be able to spend their money on other necessities, like paying bills. However, because people view in-kind grants differently than they see an equivalent amount of money, food stamp recipients might actually buy more food than they did before receiving food stamps. This would be an example of the “flypaper effect.”

While there are many potential explanations for the flypaper effect, several people, including Richard Thaler, suggest that this may be due to the ways people categorize and make their financial decisions, something called “mental accounting.” Mental accounting explains that people group different types of spending into different mental categories or “mental accounts”, which may result in seemingly irrational behavior. The flypaper effect happens because people fail to mentally transfer money between their different mental accounts. Continuing with the food stamps example, if people have a certain amount of money in their mental “groceries” account, then when they receive food stamps, it is as if they have more money in their groceries account. Instead of mentally transferring this extra money from their groceries account to, for instance, their “gas” account, people behave as if they are richer with respect to food, and they buy either more expensive food or greater quantities of food.

Although this could be a potential problem for the food stamps program, the flypaper effect could actually be used to improve microfinance initiatives in developing countries. Specifically, it could be used to get small business owners to invest more money and energy in their business.

Source: http://mamahope.wordpress.com/

For example, when researchers gave small Ghanaian business owners equipment or materials for their businesses, they behaved as if they were richer with respect to their business account: They spent more money on business-related items instead of using the extra money for household expenses, and this improved their situation. This was not true for the business owners who received an equal value in cash.

People also invest more money in their business if they receive a subsidy in an individual bank account as opposed to a joint (i.e., husband and wife) bank account. The researchers who discovered this phenomenon in rural Kenya argue that people “activate different behavioral savings rules” for these different accounts. People treat the individual bank account more like a “business account” and the joint bank account more like a “household” account, and thus, decide their account spending accordingly.

(Photo by Bryce Yukio Adolphson, © 2011)

Thus, even though mental accounting can cause people to make poor decisions, it can sometimes work in their favor. The studies I described above indicate that microfinance institutions will have more success improving small businesses with in-kind loans rather than cash loans, and also more success with subsidies to individual, as opposed to joint, bank accounts. Might the flypaper effect also have implications for encouraging other types of saving among the poor? Or more spending on education? Would in-kind grants for vaccinations or routine physicals encourage greater uptake of and spending on preventative healthcare measures?

(For more, see Development Impact.)