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Optimal irrational behavior

Author

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

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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Suggested Citation

  • Feigenbaum, James & Caliendo, Frank N. & Gahramanov, Emin, 2009. "Optimal irrational behavior," Working Papers eco_2009_01, Deakin University, Department of Economics.
  • Handle: RePEc:dkn:econwp:eco_2009_01
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    File URL: http://dx.doi.org/10.1016/j.jebo.2010.11.002
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    References listed on IDEAS

    as
    1. 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.
    2. 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.
    3. 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 164-187, February.
    4. Allen, Todd W. & Carroll, Christopher D., 2001. "Individual Learning About Consumption," Macroeconomic Dynamics, Cambridge University Press, vol. 5(02), pages 255-271, April.
    5. repec:pit:wpaper:368 is not listed on IDEAS
    6. Philippe Weil, 2008. "Overlapping Generations: The First Jubilee," Journal of Economic Perspectives, American Economic Association, vol. 22(4), pages 115-134, Fall.
    7. 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.
    8. Robert M. Solow, 1956. "A Contribution to the Theory of Economic Growth," The Quarterly Journal of Economics, Oxford University Press, vol. 70(1), pages 65-94.
    9. John Geanakoplos, 2008. "Overlapping Generations Models of General Equilibrium," Levine's Working Paper Archive 122247000000002225, David K. Levine.
    10. 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.
    11. Feigenbaum, James, 2008. "Information shocks and precautionary saving," Journal of Economic Dynamics and Control, Elsevier, vol. 32(12), pages 3917-3938, December.
    12. 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.
    13. 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, July.
    14. John Geanakoplos, 2008. "Overlapping Generations Models of General Equilibrium," Cowles Foundation Discussion Papers 1663, Cowles Foundation for Research in Economics, Yale University.
    15. Skinner, Jonathan, 1988. "Risky income, life cycle consumption, and precautionary savings," Journal of Monetary Economics, Elsevier, vol. 22(2), pages 237-255, September.
    16. Ayşe İmrohoroğlu & Selahattin İmrohoroğlu & Douglas H. Joines, 2003. "Time-Inconsistent Preferences and Social Security," The Quarterly Journal of Economics, Oxford University Press, vol. 118(2), pages 745-784.
    17. 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.
    18. Robert E. Lucas Jr., 2003. "Macroeconomic Priorities," American Economic Review, American Economic Association, vol. 93(1), pages 1-14, March.
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    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. Optimal irrationality
      by Economic Logician in Economic Logic on 2009-09-02 19:34:00

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    1. repec:eee:jeborg:v:146:y:2018:i:c:p:65-105 is not listed on IDEAS
    2. 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.
    3. Howitt, Peter & Özak, Ömer, 2014. "Adaptive consumption behavior," Journal of Economic Dynamics and Control, Elsevier, vol. 39(C), pages 37-61.
    4. Feigenbaum, James, 2016. "Equivalent representations of non-exponential discounting models," Journal of Mathematical Economics, Elsevier, vol. 66(C), pages 58-71.

    More about this item

    Keywords

    consumption; saving; coordination; lifecycle/permanent income hypothesis; SMarT Plan; general equilibrium; rules of thumb; pecuniary externality;

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • D11 - Microeconomics - - Household Behavior - - - Consumer Economics: Theory
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth

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