CAN SMALL DEVIATIONS FROM RATIONALITY MAKE SIGNIFICANT

DIFFERENCES TO ECONOMIC EQUILIBRIA?

George A. Akerlof and Janet L. Yellen

OUTLINE Introduction Implications of the Envelope Theorem Near-Rational Behavior in a Pure Exchange Economy The Welfare Effects of Near-Rational Behavior in the presence of Distortions Monopoly and Technical Change The welfare Consequences of Money Supply Shocks

Conclusion

INTRODUCTION Is a small amount of nonmaximizing behavior by agents capable if causing changes in the equilibrium in the system?

As we saw in the lectures by Dr. Fatemi, There’re serious decisions biases such as inertia, rules of thumb , …

These biases can be accounted for phenomena that have been puzzling in the context of economic theory based strict maximization such as the persistence of cartels and the existence of the business cycle.

Fundenberg(1982), Kreps(1982), Rander(1980), Waldman(1985), Russell and Thaler(1985) have examined the effects of other decision biases on the equilibrium of an economy.

IMPLICATIONS OF THE ENVELOPE THEOREM: THE BASIC LOGIC OF THE PAPER Consider the unconstrained maximization problem:

Max f(x,a)x: a choice variablea: a vector of parameters or exogenous variables x(a): the unique maximizing choice given aM(a) = f(x(a),a): the maximum value of f for given aAccording to the envelope theorem:

dM(a)/da =

IMPLICATIONS OF THE ENVELOPE Of F.O.C, we have: = 0 A agent behaving inertially, leaving x unchanged, will incur

= f(, ) – f(, ) Taylor-series expansion around :

)

IMPLICATIONS OF THE ENVELOPE Define, e = – , then:

Where normally differs from zero, thus:(e) =*

IMPLICATIONS OF THE ENVELOPE P : relative prices P = p(e,β) Define s(e,β) = p(e,β) - p(e,0), gives the systematic effect of nonmaximizing behavior.

Taylor- series expansion of s around (0,β):s(e,β) *

NEAR-RATIONAL BEHAVIOR IN A PURE EXCHANGE ECONOMY Proposition 1:

(e,β) = u(p(e, β),p(e, β) = +(-) ]

NEAR-RATIONAL BEHAVIOR IN A PURE EXCHANGE ECONOMY Proposition 2:

Monopoly and Technical Change - The profit loss = The difference between deadweight losses:: BJHC

The welfare Consequences of Money Supply Shocks The Initial Equilibrium: U = S.t. M + PG = / The sock: Money rain For maximizers: (+ (1+e)) Market clearing condition: β+(1- β) (+ (1+e))= (1+e)

THE WELFARE CONSEQUENCES OF MONEY SUPPLY SHOCKS Define θ = In the new EQU: θ = *e > e, for 0 < β < 1 Now, we should compute the loss in the average utility. Equivalently, this can be seen in the loss of utility of the average person.

For this person, G is not changed and M/P declines e(.Thus, ) = -

: the elasticity of utility with respect to money, : percentage change in money balances due to 1 percent change in the money supply

CONCLUSION There are serious welfare and policy implications due to decision biases identified.