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Boundedly Rational Dynamic Programming: Some Preliminary Results

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  • Gabaix, Xavier

Abstract

A key open question in economics is the practical, portable modeling of bounded rationality. In this short note, I report on ongoing progress that is more fully developed elsewhere. I present some results from a new model with boundedly rational features in which the decision-maker (DM) builds a simplified representation of the world. The model allows to model boundedly rational dynamic programming in a parsimonious and quite tractable way. I illustrate the approach via a boundedly rational version of the consumption-saving life cycle problem. The consumer can pay attention to the variables such as the interest rate and his income, or replace them, in his mental model, by their average values. Endogenously, the consumer pays little attention to interest rate but pays keen attention to his income. One consequence of this is that Euler equations will be biased, and the intertemporal elasticity of substitution will be biased toward 0, in a manner that is quantitatively important.

Suggested Citation

  • Gabaix, Xavier, 2012. "Boundedly Rational Dynamic Programming: Some Preliminary Results," CEPR Discussion Papers 8813, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:8813
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    References listed on IDEAS

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    1. Xavier Gabaix & David Laibson, 2018. "Shrouded attributes, consumer myopia and information suppression in competitive markets," Chapters, in: Victor J. Tremblay & Elizabeth Schroeder & Carol Horton Tremblay (ed.), Handbook of Behavioral Industrial Organization, chapter 3, pages 40-74, Edward Elgar Publishing.
    2. Xavier Gabaix & David Laibson, 2002. "The 6D Bias and the Equity-Premium Puzzle," NBER Chapters, in: NBER Macroeconomics Annual 2001, Volume 16, pages 257-330, National Bureau of Economic Research, Inc.
    3. Xavier Gabaix, 2014. "A Sparsity-Based Model of Bounded Rationality," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 129(4), pages 1661-1710.
    4. Ravi Bansal & Amir Yaron, 2004. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," Journal of Finance, American Finance Association, vol. 59(4), pages 1481-1509, August.
    5. Raj Chetty, 2012. "Bounds on Elasticities With Optimization Frictions: A Synthesis of Micro and Macro Evidence on Labor Supply," Econometrica, Econometric Society, vol. 80(3), pages 969-1018, May.
    6. Richard H. Thaler, 2008. "Mental Accounting and Consumer Choice," Marketing Science, INFORMS, vol. 27(1), pages 15-25, 01-02.
    7. Xavier Gabaix, 2012. "Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 127(2), pages 645-700.
    8. Andreas Fuster & David Laibson & Brock Mendel, 2010. "Natural Expectations and Macroeconomic Fluctuations," Journal of Economic Perspectives, American Economic Association, vol. 24(4), pages 67-84, Fall.
    9. Hall, Robert E, 1988. "Intertemporal Substitution in Consumption," Journal of Political Economy, University of Chicago Press, vol. 96(2), pages 339-357, April.
    10. Sims, Christopher A., 2003. "Implications of rational inattention," Journal of Monetary Economics, Elsevier, vol. 50(3), pages 665-690, April.
    11. Robert J. Barro, 2009. "Rare Disasters, Asset Prices, and Welfare Costs," American Economic Review, American Economic Association, vol. 99(1), pages 243-264, March.
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    Cited by:

    1. Rüdiger Bachmann & Tim O. Berg & Eric R. Sims, 2015. "Inflation Expectations and Readiness to Spend: Cross-Sectional Evidence," American Economic Journal: Economic Policy, American Economic Association, vol. 7(1), pages 1-35, February.
    2. Gabriel Garber & Márcio Issao Nakane, 2016. "Undue charges and price discrimination," Working Papers, Department of Economics 2016_27, University of São Paulo (FEA-USP).

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    More about this item

    Keywords

    Behavioral economics; Bounded rationality; Inattention; Intertemporal elasticity of substitution;
    All these keywords.

    JEL classification:

    • D03 - Microeconomics - - General - - - Behavioral Microeconomics: Underlying Principles
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth

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