Knowledge that Transforms

Interest in behavioral economics has grown in recent years, stimulated largely by accumulating evidence that the standard model of consumer decision making provides an inadequate, positive description of human behavior. Behavioral models are increasingly finding their way into policy evaluation, which inevitably involves welfare analysis. No consensus concerning the appropriate standards and criteria for behavioral welfare analysis has emerged yet. This paper summarizes our effort to develop a unified framework for behavioral welfare economics (for a detailed discussion see Bernheim and Rangel 2007) — one that can be viewed as a natural extension of standard welfare economics. Standard welfare analysis is based on choice, not on utility or preferences. In its simplest form, it instructs the planner to respect the choices an individual would make for himself. The guiding normative principle is an extension of the libertarian deference to freedom of choice, which takes the view that it is better to give a person the thing he would choose for himself rather than something that someone else would choose for him. We show that it is possible to extend the standard choice-theoretic approach to welfare analysis to situations where individuals make inconsistent choices, which are prevalent in behavioral economics.

We elicit traders' predictions of future price trajectories in repeated experimental markets for a 15-period-lived asset. We find that individuals' beliefs about prices are adaptive, and primarily based on past trends in the current and previous markets in which they have participated. Most traders do not anticipate market downturns the first time they participate in a market, and, when experienced, they typically overestimate the time remaining before market peaks and downturns occur. When prices deviate from fundamental values, belief data are informative to an observer in predicting the direction of future price movements and the timing of market peaks.

Many individuals are motivated to exert effort because they care about their jobs, rather than because there are monetary consequences to their actions. The intrinsic motivation of bureaucrats is the focus of this paper, and three primary results are shown. First, bureaucrats should be biased. Second, sometimes this bias takes the form of advocating for their clients more than would their principal, while in other cases, they are more hostile to their interests. For a range of bureaucracies, those who are biased against clients lead to more efficient outcomes. Third, self-selection need not produce the desired bias. Instead, selection to bureaucracies is likely to be bifurcated, in the sense that it becomes composed of those who are most preferred by the principal, and those who are least preferred.

The principal motivating factor in our lives is the pursuit of happiness. In most cultures, when seeking this end, individuals place a high priority on income, and spend much of their waking time procuring this intermediate goal. The connection between income and happiness is by no means trivial, however. Two critical factors come into play. First, beyond subsistence level, the positive effect of a permanent change in income tends to be short lived. We rapidly become accustomed to a more expensive lifestyle. A common name for this feature is habit formation. Second, the satisfaction derived from a given level of income is sharply dependent on how it compares to the income of peers. See, for example, Andrew B. Abel (1990), Becker (1996), and William A. Brock and Steven N. Durlauf (2001) for a demonstration of the influence of habits and peer comparisons over behavior, and see Shane Frederick and George Loewenstein (1999) for a review of the underlying psychology. Habits and peer comparisons mean that an individual is not concerned mainly with her absolute level of income, but rather with the difference between her income and a benchmark that changes over time. In recent years, economists have become increasingly interested in this fact. This interest has been both applied (i.e., the study of habits and peer influences over behavior and the analysis of happiness surveys) and theoretical (i.e., a search for biological foundations). But unlike other more developed areas of economics, these two approaches remain fairly separate from each other. In particular, the existing theoretical work is motivated only by the most basic empirical observations. And the existing applied work, for the most part, has not been influenced by theoretical results. In this essay, we seek to reduce the distance between these two literature strands. In particuHabits, Peers, and Happiness: An Evolutionary Perspective

Economics has always been concerned not only with describing or predicting economic behavior but also with understanding economic well-being. The traditional, official way economists (claimed to) have assessed well-being is from “revealed preference’’—observing what people choose under the maintained hypothesis of 100 percent rationality. For instance, when we teach millions of students each year the conditions under which interfering with free-market exchange will make people worse off, by interfering with satisfying their wants, we do so under the compelling assumption that people tend to make choices that rationally maximize their own well-being. While economists are humble about the fact that we are not in a privileged position to declare what goals society should pursue, welfare economics has provided guidance on the determinants of well-being according to this restrictive set of criteria. Although all of us also assess well-being in other ways, it is only recently that economists have begun to do so in a more focused way. A growing number of researchers have begun to study alternatives to the 100 percent rationality assumption, while other researchers have used sundry techniques to measure well-being directly. In this article, we explore some conceptual issues as to why and how one might use these new assumptions and approaches to supplement and modify the revealed-preference approach as it is conventionally conceived. We take the central question of welfare economics to be: how do different situations or economic environments affect people’s well-being? When doing so with sensible ancillary assumptions, inferring people’s well-being from their choices, based on the presumption that they are rationally pursuing their goals, is, in our view, the best scientific approach to research on well-being yet formulated. Our first goal in this

The existing literature typically does not differentiate between security returns and the returns of investors in these securities. This study clarifies that investor and security returns differ because of the timing and magnitude of investor capital flows into and out of these securities. The empirical results indicate that actual investor returns are systematically lower than buy-and-hold returns for nearly all major international stock markets. These results imply that the historical equity premium and the cost of equity capital are likely lower than previously thought.

�Inattentive agents update their information sporadically, and thus respond belatedly to news. We generate optimally inattentive behavior by assuming that to observe the value of his investment portfolio the consumer must pay a cost that is proportional to the portfolio’s contempo raneous value. It is optimal for the consumer to check his investment portfolio at equally spaced points in time, consuming from a riskless trans actions account in the interim. The riskless transactions account that finances consump tion guarantees that funds are never unwittingly exhausted. � We show that the optimal interval of time between consecutive observations of the value of the portfolio is the unique positive solution to a nonlinear equation. Quantitatively, even a small observation cost (one basis point of wealth) implies a substantial (eight-month) decision interval under conventional parameter values.

Quitting rights play a major role in many economic interactions, whether in the precontractual phase or after contracts have been signed. Clearly, no party can be forced to sign a contract if she is unwilling to, thus implying that quitting rights can be exerted at the ex ante stage when no contract has been signed. But, quitting rights can also be exerted after explicit contracts have been signed in a number of instances. For example, most labor contracts allow employees to leave their job if they want to. Also, quitting rights may be asymmetric across agents as labor contracts illustrate. (Employers are generally constrained in their ability to replace their employees.)

Central banks target CPI inflation; independent central banks are concerned about their balance sheet and the level of their capital. The first fact makes it difficult for a central bank to implement the optimal escape from a liquidity trap, because it undermines a commitment to overshoot the inflation target. We show that the second fact provides a solution. Capital concerns provide a mechanism for an independent central bank to commit to inflate ex post. The optimal policy can take the form of a currency depreciation combined with a crawling peg, a policy advocated by Svensson as the “Foolproof Way” to escape from a liquidity trap.

*This paper is based on a long-term research program with Rachel Kranton on the implications of identity for economic behavior and also a manuscript we are currently writing on the missing motivation in economics. Our previous joint papers (Akerlof and Kranton (2000), (2002) and (2005)) have explored implications outside of macroeconomics of utility functions dependent on peoples notions of what ought to be. Conversations with Kranton have also been the basis for the section on economic methodology. I have also benefitted from conversations with Robert Shiller, with whom I am co-authoring work on behavioral macroeconomics. In addition, I