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Optimal Irrational Behavior

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Author Info
James Feigenbaum ()
Frank N. Caliendo
Emin Gahramanov

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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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File URL: http://www.deakin.edu.au/buslaw/aef/workingpapers/papers/2009_1.pdf
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Publisher 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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Find related papers by JEL classification:
C61 - Mathematical and Quantitative Methods - - Mathematical Methods and Programming - - - Optimization Techniques; Programming Models; Dynamic Analysis
D11 - Microeconomics - - Household Behavior - - - Consumer Economics: Theory
E21 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. John Geanakoplos, 2008. "Overlapping Generations Models of General Equilibrium," Levine's Bibliography 122247000000002225, UCLA Department of Economics. [Downloadable!]
  2. Allen, Todd W. & Carroll, Christopher D., 2001. "Individual Learning About Consumption," Macroeconomic Dynamics, Cambridge University Press, vol. 5(02), pages 255-271, April. [Downloadable!]
    Other versions:
  3. Shlomo Benartzi & Richard H. Thaler, 2001. "Naive Diversification Strategies in Defined Contribution Saving Plans," American Economic Review, American Economic Association, vol. 91(1), pages 79-98, March. [Downloadable!] (restricted)
  4. John Geanakoplos, 2008. "Overlapping Generations Models of General Equilibrium," Cowles Foundation Discussion Papers 1663, Cowles Foundation, Yale University. [Downloadable!]
  5. James Feigenbaum, 2006. "Precautionary Saving Unfettered," Working Papers 227, University of Pittsburgh, Department of Economics, revised Jan 2006. [Downloadable!]
    Other versions:
  6. 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. [Downloadable!] (restricted)
  7. Skinner, Jonathan, 1988. "Risky income, life cycle consumption, and precautionary savings," Journal of Monetary Economics, Elsevier, vol. 22(2), pages 237-255, September. [Downloadable!] (restricted)
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  8. Feigenbaum, James, 2008. "Information shocks and precautionary saving," Journal of Economic Dynamics and Control, Elsevier, vol. 32(12), pages 3917-3938, December. [Downloadable!] (restricted)
  9. 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. [Downloadable!] (restricted)
    Other versions:
  10. 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. [Downloadable!] (restricted)
    Other versions:
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