Optimal Irrational Behavior
Journalof Economic Behavior and Organizations
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.
Feigenbaum, James A., (2011), “Precautionary Saving or Denied Dissaving,” Economic Modelling 28: 1559-1572. Feigenbaum, James A., Frank N. Caliendo, and Emin Gahramanov, (2011), “Optimal Irrational Behavior,” Journal of Economic Behavior and Organizations 77: 286-304.