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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. Philippe Weil, 2008. "Overlapping generations: the first jubilee," ULB Institutional Repository 2013/13430, ULB -- Universite Libre de Bruxelles.
  2. Richard H. Thaler & Shlomo Benartzi, 2001. "Naive Diversification Strategies in Defined Contribution Saving Plans," American Economic Review, American Economic Association, American Economic Association, vol. 91(1), pages 79-98, March.
  3. 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.
  4. Ayse Imrohoroglu & Selahattin Imrohoroglu & Douglas H. Joines, 2000. "Time inconsistent preferences and Social Security," Discussion Paper / Institute for Empirical Macroeconomics, Federal Reserve Bank of Minneapolis 136, Federal Reserve Bank of Minneapolis.
  5. Feigenbaum, James, 2008. "Information shocks and precautionary saving," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 32(12), pages 3917-3938, December.
  6. James Feigenbaum, 2006. "Precautionary Saving Unfettered," Computing in Economics and Finance 2006, Society for Computational Economics 29, Society for Computational Economics.
  7. Feigenbaum, James & Caliendo, Frank N., 2010. "Optimal irrational behavior in continuous time," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 34(10), pages 1907-1922, October.
  8. 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.
  9. John Geanakoplos, 2008. "Overlapping Generations Models of General Equilibrium," Levine's Working Paper Archive 122247000000002225, David K. Levine.
  10. James Bullard & James Feigenbaum, 2006. "A leisurely reading of the life-cycle consumption data," Working Papers, Federal Reserve Bank of St. Louis 2003-017, Federal Reserve Bank of St. Louis.
  11. Feigenbaum, James & Caliendo, Frank N. & Gahramanov, Emin, 2011. "Optimal irrational behavior," Journal of Economic Behavior & Organization, Elsevier, Elsevier, vol. 77(3), pages 285-303, March.
  12. Christopher D Carroll & Miles S Kimball, 2001. "Liquidity Constraints and Precautionary Saving," Economics Working Paper Archive, The Johns Hopkins University,Department of Economics 455, The Johns Hopkins University,Department of Economics.
  13. 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.
  14. Chris Shannon, 2003. "What to Maximize if You Must," Theory workshop papers, UCLA Department of Economics 658612000000000044, UCLA Department of Economics.
  15. 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.
  16. John Geanakoplos, 2008. "Overlapping Generations Models of General Equilibrium," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 1663, Cowles Foundation for Research in Economics, Yale University.
  17. Balasko, Yves & Shell, Karl, 1980. "The overlapping-generations model, I: The case of pure exchange without money," Journal of Economic Theory, Elsevier, Elsevier, vol. 23(3), pages 281-306, December.
  18. Richard Thaler & Shlomo Benartzi, 2004. "Save more tomorrow: Using behavioral economics to increase employee saving," Natural Field Experiments, The Field Experiments Website 00337, The Field Experiments Website.
  19. 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.
  20. Skinner, Jonathan, 1988. "Risky income, life cycle consumption, and precautionary savings," Journal of Monetary Economics, Elsevier, Elsevier, vol. 22(2), pages 237-255, September.
  21. Robert E. Lucas Jr., 2003. "Macroeconomic Priorities," American Economic Review, American Economic Association, 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
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Cited by:
  1. James Feigenbaum, 2008. "Optimal Irrational Behavior," Working Papers, University of Pittsburgh, Department of Economics 368, University of Pittsburgh, Department of Economics, revised Sep 2008.
  2. Peter Howitt & Ömer Özak, 2009. "Adaptive Consumption Behavior," NBER Working Papers 15427, National Bureau of Economic Research, Inc.
  3. Feigenbaum, James & Caliendo, Frank N., 2010. "Optimal irrational behavior in continuous time," Journal of Economic Dynamics and Control, Elsevier, 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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