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Optimal Irrational Behavior

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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(TM) (SMarT) Plan can confer higher lifetime utility than the permanent-income rule in general equilibrium.

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File URL: ftp://repec.bus.usu.edu/RePEc/uth/wpaper/DEFWP2009-01.pdf
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Bibliographic Info

Paper provided by Utah State University, Department of Economics and Finance in its series Working Papers with number 200901.

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Length: 39 pages
Date of creation: 03 Feb 2009
Date of revision:
Handle: RePEc:uth:wpaper:200901

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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. James Feigenbaum, 2006. "Precautionary Saving Unfettered," Computing in Economics and Finance 2006 29, Society for Computational Economics.
  2. Todd W. Allen & Christopher D. Carroll, 2001. "Individual Learning About Consumption," NBER Working Papers 8234, National Bureau of Economic Research, Inc.
  3. Aviad Heifetz & Chris Shannon & Yossi Spiegel, 2004. "What to Maximize if You Must," Discussion Papers 1414, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  4. 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.
  5. Lawrence Blume & David Easley, 2006. "If You're so Smart, why Aren't You Rich? Belief Selection in Complete and Incomplete Markets," Econometrica, Econometric Society, vol. 74(4), pages 929-966, 07.
  6. Christopher D. Carroll & Miles S. Kimball, 2001. "Liquidity Constraints and Precautionary Saving," NBER Working Papers 8496, National Bureau of Economic Research, Inc.
  7. Richard Thaler & Shlomo Benartzi, 2004. "Save more tomorrow: Using behavioral economics to increase employee saving," Natural Field Experiments 00337, The Field Experiments Website.
  8. John Geanakoplos, 2008. "Overlapping Generations Models of General Equilibrium," Levine's Working Paper Archive 122247000000002225, David K. Levine.
  9. Philippe Weil, 2008. "Overlapping generations: the first jubilee," ULB Institutional Repository 2013/13430, ULB -- Universite Libre de Bruxelles.
  10. Jonathan S. Skinner, 1987. "Risky Income, Life Cycle Consumption, and Precautionary Savings," NBER Working Papers 2336, National Bureau of Economic Research, Inc.
  11. Robert E. Lucas Jr., 2003. "Macroeconomic Priorities," American Economic Review, American Economic Association, vol. 93(1), pages 1-14, March.
  12. James Feigenbaum & Frank N. Caliendo & Emin Gahramanov, 2009. "Optimal Irrational Behavior," Working Papers 200901, Utah State University, Department of Economics and Finance.
  13. 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.
  14. James Bullard & James Feigenbaum, 2006. "A leisurely reading of the life-cycle consumption data," Working Papers 2003-017, Federal Reserve Bank of St. Louis.
  15. 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.
  16. Feigenbaum, James, 2008. "Information shocks and precautionary saving," Journal of Economic Dynamics and Control, Elsevier, vol. 32(12), pages 3917-3938, December.
  17. 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.
  18. John Geanakoplos, 2008. "Overlapping Generations Models of General Equilibrium," Cowles Foundation Discussion Papers 1663, Cowles Foundation for Research in Economics, Yale University.
  19. 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.
  20. 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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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. Howitt, Peter & Özak, Ömer, 2014. "Adaptive consumption behavior," Journal of Economic Dynamics and Control, Elsevier, vol. 39(C), pages 37-61.
  2. Feigenbaum, James & Caliendo, Frank N. & Gahramanov, Emin, 2011. "Optimal irrational behavior," Journal of Economic Behavior & Organization, Elsevier, vol. 77(3), pages 285-303, March.
  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.

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