Optimal irrational behavior

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™ (SMarT) Plan, if properly parameterized, can confer higher lifetime utility than the permanent-income rule.

Research highlights▶ The pecuniary externality can be exploited in an overlapping-generations model. ▶ Irrational rules of thumb can improve welfare for agents interacting in markets. ▶ A small number of rational agents will not spoil improvement for irrational agents. ▶ We parameterize the SMarT Plan in a continuous-time model to improve welfare.