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Optimal Irrational Behavior

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  • James Feigenbaum

    ()

  • Frank N. Caliendo
  • Emin Gahramanov

Abstract

Contrary to the usual presumption that welfare is maximized if consumers behave rationally, we show in a two-period overlapping generations model that there always exists a rule of thumb that can weakly improve upon the lifecycle/permanent-income rule in general equilibrium with irrational households. 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 this effect. For typical calibrations, the improvement of the welfare of irrational households is robust to the introduction of rational agents. Generalizing to a more realistic lifecycle model, we find in particular that the Save More Tomorrow Plan can confer higher lifetime utility than the permanent-income rule in general equilibrium.

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Bibliographic Info

Paper provided by Deakin University, Faculty of Business and Law, School of Accounting, Economics and Finance in its series Economics Series with number 2009_01.

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Length: 39
Date of creation: 10 Feb 2009
Date of revision:
Handle: RePEc:dkn:econwp:eco_2009_01

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Related research

Keywords: consumption; saving; coordination; lifecycle/permanent income hypothesis; SMarT Plan; general equilibrium; rules of thumb; pecuniary externality;

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References

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  1. 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, University of Chicago Press, vol. 112(S1), pages S164-S187, February.
  2. Richard Thaler & Shlomo Benartzi, 2004. "Save more tomorrow: Using behavioral economics to increase employee saving," Natural Field Experiments 00337, The Field Experiments Website.
  3. James Feigenbaum & Frank N. Caliendo & Emin Gahramanov, 2009. "Optimal Irrational Behavior," Economics Series 2009_01, Deakin University, Faculty of Business and Law, School of Accounting, Economics and Finance.
  4. Robert E. Lucas Jr., 2003. "Macroeconomic Priorities," American Economic Review, American Economic Association, vol. 93(1), pages 1-14, March.
  5. Heifetz, Aviad & Shannon, Chris & Spiegel, Yossi, 2007. "What to maximize if you must," Journal of Economic Theory, Elsevier, vol. 133(1), pages 31-57, March.
  6. John Geanakoplos, 2008. "Overlapping Generations Models of General Equilibrium," Levine's Working Paper Archive 122247000000002225, David K. Levine.
  7. 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.
  8. Philippe Weil, 2008. "Overlapping generations: the first jubilee," ULB Institutional Repository 2013/13430, ULB -- Universite Libre de Bruxelles.
  9. 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.
  10. Ayse Imrohoroglu & Selahattin Imrohoroglu & Douglas H. Joines, 2003. "Time-Inconsistent Preferences And Social Security," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 118(2), pages 745-784, May.
  11. Skinner, Jonathan, 1988. "Risky income, life cycle consumption, and precautionary savings," Journal of Monetary Economics, Elsevier, vol. 22(2), pages 237-255, September.
  12. 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.
  13. Allen, Todd W. & Carroll, Christopher D., 2001. "Individual Learning About Consumption," Macroeconomic Dynamics, Cambridge University Press, Cambridge University Press, vol. 5(02), pages 255-271, April.
  14. Christopher D. Carroll & Miles S. Kimball, 2001. "Liquidity Constraints and Precautionary Saving," NBER Working Papers 8496, National Bureau of Economic Research, Inc.
  15. James Bullard & James Feigenbaum, 2006. "A leisurely reading of the life-cycle consumption data," Working Papers 2003-017, Federal Reserve Bank of St. Louis.
  16. Lawrence Blume & David Easley, 2001. "If You're So Smart, Why Aren't You Rich? Belief Selection in Complete and Incomplete Markets," Working Papers, Santa Fe Institute 01-06-031, Santa Fe Institute.
  17. James Feigenbaum, 2006. "Precautionary Saving Unfettered," Computing in Economics and Finance 2006 29, Society for Computational Economics.
  18. Findley, T. Scott & Caliendo, Frank N., 2010. "Does it pay to be SMarT?," Journal of Pension Economics and Finance, Cambridge University Press, Cambridge University Press, vol. 9(03), pages 321-344, July.
  19. John Geanakoplos, 2008. "Overlapping Generations Models of General Equilibrium," Cowles Foundation Discussion Papers 1663, Cowles Foundation for Research in Economics, Yale University.
  20. Feigenbaum, James, 2008. "Information shocks and precautionary saving," Journal of Economic Dynamics and Control, Elsevier, vol. 32(12), pages 3917-3938, December.
  21. 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.
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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
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Cited by:
  1. James Feigenbaum & Frank N. Caliendo & Emin Gahramanov, 2009. "Optimal Irrational Behavior," Economics Series 2009_01, Deakin University, Faculty of Business and Law, School of Accounting, Economics and Finance.
  2. 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.
  3. Howitt, Peter & Özak, Ömer, 2014. "Adaptive consumption behavior," Journal of Economic Dynamics and Control, Elsevier, vol. 39(C), pages 37-61.
  4. 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.

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