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Optimal irrational behavior

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

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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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
Contact details of provider: Web page: http://www.elsevier.com/locate/jebo

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  2. 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.
  3. John Geanakoplos, 2008. "Overlapping Generations Models of General Equilibrium," Cowles Foundation Discussion Papers 1663, Cowles Foundation for Research in Economics, Yale University.
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  13. 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.
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  19. Feigenbaum, James, 2008. "Information shocks and precautionary saving," Journal of Economic Dynamics and Control, Elsevier, vol. 32(12), pages 3917-3938, December.
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