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Optimal irrational behavior

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  • Feigenbaum, James
  • Caliendo, Frank N.
  • Gahramanov, Emin

Abstract

Contrary to the usual presumption that welfare in markets is maximized if consumers behave rationally, we show in a two-period overlapping generations model that there always exists an irrational consumption rule that can weakly improve upon the lifecycle/permanent-income rule in general equilibrium. The market-clearing mechanism introduces a pecuniary externality that individual rational households do not consider when making decisions but a publically shared rule of thumb can exploit. For typical calibrations, the improvement of the welfare of irrational households is robust to the introduction of rational agents. Although transitions to the optimal irrational steady state are not Pareto improving, transitions do exist that will improve a Pareto social welfare function with a sufficiently small generational discount rate. Generalizing to a more realistic lifecycle model, we find that the Save More Tomorrow(TM) (SMarT) Plan, if properly parameterized, can confer higher lifetime utility than the permanent-income rule.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Economic Behavior & Organization.

Volume (Year): 77 (2011)
Issue (Month): 3 (March)
Pages: 285-303

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Handle: RePEc:eee:jeborg:v:77:y:2011:i:3:p:285-303

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Web page: http://www.elsevier.com/locate/jebo

Related research

Keywords: Consumption Saving Coordination Overlapping generations Lifecycle/permanent-income hypothesis SMarT Plan General equilibrium Pecuniary externality Transition dynamics Bounded rationality;

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References

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  1. Chris Shannon, 2003. "What to Maximize if You Must," Theory workshop papers 658612000000000044, UCLA Department of Economics.
  2. Todd W Allen & Christopher D Carroll, 2001. "Individual Learning About Consumption," Economics Working Paper Archive 444, The Johns Hopkins University,Department of Economics.
  3. Christopher D Carroll & Miles S Kimball, 2001. "Liquidity Constraints and Precautionary Saving," Economics Working Paper Archive 455, The Johns Hopkins University,Department of Economics.
  4. John Geanakoplos, 2008. "Overlapping Generations Models of General Equilibrium," Cowles Foundation Discussion Papers 1663, Cowles Foundation for Research in Economics, Yale University.
  5. James Feigenbaum, 2008. "Optimal Irrational Behavior," Working Papers 368, University of Pittsburgh, Department of Economics, revised Sep 2008.
  6. Richard H. Thaler & Shlomo Benartzi, 2004. "Save More Tomorrow (TM): Using Behavioral Economics to Increase Employee Saving," Journal of Political Economy, University of Chicago Press, vol. 112(S1), pages S164-S187, February.
  7. Findley, T. Scott & Caliendo, Frank N., 2010. "Does it pay to be SMarT?," Journal of Pension Economics and Finance, Cambridge University Press, vol. 9(03), pages 321-344, July.
  8. Kevin X.D. Huang & Frank Caliendo, 2007. "Rationalizing Seven Consumption-Saving Puzzles in a Unified Framework," Vanderbilt University Department of Economics Working Papers 0716, Vanderbilt University Department of Economics.
  9. Skinner, Jonathan, 1988. "Risky income, life cycle consumption, and precautionary savings," Journal of Monetary Economics, Elsevier, vol. 22(2), pages 237-255, September.
  10. Feigenbaum, James & Caliendo, Frank N., 2010. "Optimal irrational behavior in continuous time," Journal of Economic Dynamics and Control, Elsevier, vol. 34(10), pages 1907-1922, October.
  11. James Feigenbaum, 2006. "Precautionary Saving Unfettered," Working Papers 227, University of Pittsburgh, Department of Economics, revised Jan 2006.
  12. Larry Blume & David Easley, 2001. "If You're So Smart, Why Aren't You Rich? Belief Selection in Complete and Incomplete Markets," Cowles Foundation Discussion Papers 1319, Cowles Foundation for Research in Economics, Yale University.
  13. Philippe Weil, 2008. "Overlapping Generations: the First Jubilee," Sciences Po publications info:hdl:2441/8712, Sciences Po.
  14. Richard Thaler & Shlomo Benartzi, 2004. "Save more tomorrow: Using behavioral economics to increase employee saving," Natural Field Experiments 00337, The Field Experiments Website.
  15. Richard H. Thaler & Shlomo Benartzi, 2001. "Naive Diversification Strategies in Defined Contribution Saving Plans," American Economic Review, American Economic Association, vol. 91(1), pages 79-98, March.
  16. Feigenbaum, James, 2008. "Information shocks and precautionary saving," Journal of Economic Dynamics and Control, Elsevier, vol. 32(12), pages 3917-3938, December.
  17. Ayse Imrohoroglu & Selahattin Imrohoroglu & Douglas H. Joines, 2000. "Time inconsistent preferences and Social Security," Discussion Paper / Institute for Empirical Macroeconomics 136, Federal Reserve Bank of Minneapolis.
  18. Bullard, James & Feigenbaum, James, 2007. "A leisurely reading of the life-cycle consumption data," Journal of Monetary Economics, Elsevier, vol. 54(8), pages 2305-2320, November.
  19. John Geanakoplos, 2008. "Overlapping Generations Models of General Equilibrium," Levine's Working Paper Archive 122247000000002225, David K. Levine.
  20. Balasko, Yves & Shell, Karl, 1980. "The overlapping-generations model, I: The case of pure exchange without money," Journal of Economic Theory, Elsevier, vol. 23(3), pages 281-306, December.
  21. Robert E. Lucas Jr., 2003. "Macroeconomic Priorities," American Economic Review, American Economic Association, vol. 93(1), pages 1-14, March.
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Citations

Blog mentions

As found by EconAcademics.org, the blog aggregator for Economics research:
  1. Optimal irrationality
    by Economic Logician in Economic Logic on 2009-09-02 14:34:00
Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
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Cited by:
  1. James Feigenbaum & Frank N. Caliendo & Emin Gahramanov, 2009. "Optimal Irrational Behavior," Working Papers 200901, Utah State University, Department of Economics and Finance.
  2. Howitt, Peter & Özak, Ömer, 2014. "Adaptive consumption behavior," Journal of Economic Dynamics and Control, Elsevier, vol. 39(C), pages 37-61.
  3. Feigenbaum, James & Caliendo, Frank N., 2010. "Optimal irrational behavior in continuous time," Journal of Economic Dynamics and Control, Elsevier, vol. 34(10), pages 1907-1922, October.
  4. Emin Gahramanov & Xueli Tang, 2014. "Impatient in Experiments, but Patient in Simulations: A Challenge to a Neoclassical Model," Economics Series 2014_2, Deakin University, Faculty of Business and Law, School of Accounting, Economics and Finance.

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