Cognitive Economics

1. Cognitive Economics • Definition: Taking seriously data other than actual choices in the wild. • Must be linked back to actual choices in the wild. • Analogous to Cognitive Psychology vs. B.F. Skinner. • Complementary to Psychological Economics, since loosening the constraints on the utility function raises the value of additional data.

2. Examples of Cognitive Economics • Experimental Economics. • Neuroeconomics. • Survey measures of expectations. • Survey measures of preference parameters based on hypothetical choices. • Happiness research.

3. Utility and Happiness Miles Kimball and Robert Willis University of Michigan http://www-personal.umich.edu/~mkimball/pdf/index.html

4. “Happiness,” as defined operationally by psychologists • On a scale from one to seven, where one is “extremely unhappy” and seven is “extremely happy,” how do you feel right now?

5. A growing economic literature uses happiness data • Provocative findings—see Layard’s Happiness • Mostly focuses on the cross-section and the long-run trend. • Motivations of the researchers: • to study the welfare implications of non-traded goods • to diagnose optimization mistakes and study welfare implications in contexts where choice behavior is potentially inconsistent. • Many other economists are skeptical: the theoretical status of happiness is unclear.

6. What is “happiness” in relation to economic theory? • Flow utility? • The individual’s overall objective function? • The part of the individual’s objective function that abstracts from the desire to do one’s duty? • The individual’s objective function plus pleasure from memory? • None of the above.

7. Distinguishing preferences and happiness as a matter of logic. • Preferences (Represented by Lifetime Utility) = The extent to which people get what they want, where what they want is indicated by their choices. • Happiness (Current Affect) = How positive people’s feelings are at a given time.

8. Why preferences and happiness matter • People’s own choices and feelings are the two non-paternalistic indicators we have for individual welfare(what makes an individual better off in the sense relevant for policy). • A priori, both seem useful.

9. The Question: What is the Relationship? • Both felt happiness and choice-based preferences are well-defined, observable concepts. • Thenature of the relationship between the standard psychological concept of happiness and the standard economic concept of preferences is an open empirical question.

10. Why the relationship between them can’t be simple: • Easterlin Paradox • Hedonic Adaptation

11. The Easterlin Paradox

12. Hedonic Adaptation(Mean Reversion of Affect) Cross-sectional evidence of hedonic adaptation for • incarceration • loss of the use of limbs • serious burns • death of a spouse • winning the lottery • winning £10,000 raises affect by six times as much in the first year as £10,000 per year in additional income. Dynamics of national happiness after big news: • “Unhappiness after Hurricane Katrina”

14. The state of the literature Existing work in Economics largely either • ignores happiness data, e.g.: “Happiness is irrelevant to Economics” OR B. assumes happiness=flow utility: “Happiness is a sufficient statistic for utility.”

15. The Middle Way In this paper, we steer a middle course between these two extremes: • Happiness ≠ Flow Utility, BUT • Happiness has a systematic relationship to utility.

16. Significance Any known, systematic relationship between happiness and preferences would • provide an important bridge between psychologyandeconomics. • allow psychological data and theory to be used in economics in a way that is complementary to standard economic data and theory. • allow all the tools of economics to be brought to bear toward understanding happiness.

17. Sketch of our Integrated Theory of Utility and Happiness Experienced happiness is the sum of two components: • elation: short-run happiness that depends on recent news about lifetime utility • baseline mood: long-run happiness that is the output of a household production function (like health, entertainment, or nutrition.)

18. Why Happiness Matters for Economics (Our View) • Preference for Happiness: Other things being equal, people prefer to be happy. • News and Happiness: Short-run spikes and dips in happiness • signal what people consider good and bad news, • which in turn signals what they prefer.

19. Preference for Happiness Axiom: Part 1 • Preferences depend on the joint stochastic process of K: vector of state variables X: vector of control variables H: vector of outputs of household production functions other than happiness A: current happiness (affect). • The current and past values of these variables are all observable to the agent.

20. Preference for Happiness Axiom: Part 2 • Consider two information trees Y1and Y2induced by two different strategies in the game against nature over the same time. • If f1(t,p) and f2(t,p) map to nodes in the two trees so that • the measure of p gives subjective probabilities • fi(t-h,p) maps to the ancestor node of fi(t,p) • (K,X,H)(f2(t,p))=(K,X,H)(f1(t,p)) w.p. 1 • A(f2(t,p))≥A(f1(t,p)) w.p. 1, • then Y2 (weakly) preferred to Y1.

21. Evidence in Favor of a Preference for Happiness The preference for happiness shows up in both household and firm behavior: • Purchases of therapy, Prozac, self-help books, magazines featuring “happiness.” • Advertising that tries to suggest that a product will make one feel happy.

22. Relationship to the Orthodoxy of Other Happiness Researchers • People value happiness (and will sacrifice other goods for it) versus • People should be maximizing happiness (economists often interpret this as saying that happiness is the true utility function).

23. News andHappiness • The relationship between circumstances and happiness is weak in the long run, BUT • No one disputes that in the short run happiness responds in an intuitive way to news about lifetime utility. • Thus, we argue that an important component of happiness is due to recent news about lifetime utility.

24. ‘Elation’ and ‘Dismay’ • ‘elation’ = the component of happiness due to recent news about lifetime utility. • ‘dismay’ = -elation

25. Elation and Hedonic Adaptation • If expectations are rational, standard results about rational expectations imply that elation will be strongly mean reverting. Intuitively, • News doesn’t stay news for very long. • The initial burst of elation dissipates once the full import of news is emotionally and cognitively processed. • Relevance to the Hedonic Treadmill, a.k.a. the Easterlin Paradox.

26. The Happiness and News Axioms • Happiness is a function of K and X and - additional state variable vector J - additional control variable vector Q - the history of lifetime utility. Fixing K, X, J and Q, b. Happierif currentexpected lifetime utility is of a preferred future. c. Less happy if past expected lifetime utility was of a preferred future.

27. The Innovation ιin Lifetime Utility v(Time-Separable Intertemporal Expected Utility Preferences) Note about the lifetime utility innovation: so

28. Happiness Function Implied by Happiness and News Axioms + Standard Additively Separable Expected Utility

29. Key Implications of the Happiness and News Axioms • A theory of happiness can be described in terms of the objects that are well-defined by revealed preference: • The fundamentals (state and control variables and outputs of household production functions) that people care about and • The history of which indifference curves for lifetime plans one has been on. • Old news about the future matters less for happiness than recent news about the future.

30. The Integrated Theory with Additively Time-Separable IEU Preferences vt = lifetime utility Et= rational expectation as of time t β = utility discount factor U =flow utility K = state vector: individual wealth, weather, prices, tax rates, pollution, average level of consumption in society… X = control vector: consumption, time use,… H = outputs of household production functions: subjective health, weight, fatigue, being alive, spouse being alive,…

31. The Integrated Theory with Standard Preferences (cont.) J=state variables that do not matter directly for preferences but affect household production: genes, underlying physical and psychological states, unknown parameter values, unknown shocks,… Q=control variables that do not matter directly for preferences, but affect household production: psychoactive and other medical drugs, recreational drugs,… ι=lifetime utility innovation.

32. Special Case #1: Additively Separable Happiness U(K,X,H,A)=F(K,X,H)+Ψ(A)

33. Baseline Mood M and Elation e.

34. Special Case #1: Preferences do not depend on happiness (but happiness depends on preferences) U(K,X,H)

35. Special Case #2: Additively Separable Happiness U(K,X,H,A)=F(K,X,H)+M(K,X,J,Q) +e(K,X,J,Q, ιt, ιt-1,…)

36. Special Case #3: Additively Separable Happiness with Elation Linear in Lifetime Utility Innovations U(K,X,H,A)=F(K,X,H)+M(K,X,J,Q) +α0ιt + α1ιt-1 + …

37. 7. Why Utility and Happiness are Often Confused • If baseline mood is exogenous to the individual, and elation is linear in lifetime utility innovations, maximizing any positive linear combination of current and expected future happiness is equivalent to maximizing lifetime utility.

38. Why are Utility and Happiness Confused? (continued) • Elation and dismay may dominate people’s perception of happiness, but without much conscious awareness of the resetting of the implicit reference point that depends on past expectations of lifetime utility. • The reference point is a sunk cost that does not affect maximization, so lack of awareness of it is not a problem.

39. 8. Elation in the Utility Function So far, a. flow utility = U(Kt, Xt, M(Kt, Xt)) What if b. flow utility = U(Kt, Xt, M(Kt, Xt)) +b0ιt+b1ιt-1+b2ιt-2+… c. or flow utility = U(Kt, Xt, M(Kt, Xt),e(ιt,ιt-1,ιt-2,…)) )

40. Elation in the Utility Function Might Not Change a Thing • Given rational expectations, adding a linear combination of lifetime utility innovations to the utility function has no effect on the preferences represented. • In this case, mistakes about the rate of hedonic adaptation cause no material harm to utility maximization.

41. Can Manipulating One’s Perceptions Raise Utility? • With elation in the utility function, manipulating ones perception of lifetime utility innovations becomes an issue. • Lowering expectations is mostly a wash because it lowers happiness now in order to raise happiness later. It may also interfere with optimization. • The greatest potential gain from manipulating one’s perceptions is to lower one’s memory of past expectations. (“Attitude of gratitude”)

42. Manipulating Perceptions of Locus of Control • Elation may respond more to news about whether one’s choices worked out than to news about things beyond one’s control. • This would make it possible to manipulate elation by labeling good events as due to one’s efforts, while bad events were beyond one’s control.

43. Elation and Prospect Theory • In the nonlinear case, elation theory yields prospect theory very naturally. In particular, if a. Elation is roughly proportional to the rate of cognitive processing of news. b. Bad news requires more processing than good news. c. Within bad or good news, the total amount of processing needed is proportional or less than proportional to the magnitude of the news. • Thus, Prospect Theory can arise from rational preferences over one’s own emotions.

44. Baseline Mood and Health Like health, baseline mood • can be measured independently of Kt and Xt • is only one argument of the flow utility function • depends on different things than flow utility does (or on the same things with different weights) • has a complex household production function

45. What does Baseline Mood Depend on? • Any persistent aspect of happiness is part of baseline mood. Genes are the biggest factor. Also, there is some evidence that each of the following has a persistent effect on happiness: a. Prozac b. sleep c. exercise d. good eating habits e. social rank • + pleasantness of one’s current activity

46. Do People Know the Production Function for Baseline Mood? • Just as people don’t know the true production function for health, they may not know the true production function for baseline mood. • Lack of understanding of the dynamics of the elation mechanism could make it difficult for individuals to parcel out the determinants of baseline mood. • The discovery and dissemination of facts about the determinants of baseline mood could have large positive welfare effects • A big deal if the share of the money and time budget devoted to baseline mood trends up.

47. Applying Price Theory to Baseline Mood: The Demand for Prozac • If you learn more about the household production function for happiness, your behavior will change in a direction that takes advantage of that to raise happiness. • Example: Demand for Prozac will go up if information arrives that it is more effective in raising happiness than previously thought (with no new information about side effects). • Demand will go down if information arrives that it is less effective at raising happiness than previously thought.

48. Applying Price Theory to Baseline Mood • Materialism lowers happiness (weak, but interesting evidence). • Tradeoff between happiness and other goods. • Materialism means higher preferences for other goods compared to happiness.

49. Applying Price Theory to Baseline Mood • Is baseline mood a luxury good? • Even normality of baseline mood leads to a version of the Easterlin Paradox: Why don’t people buy higher baseline mood as part of their expanding consumption bundle? • Three potential answers: • Some uptrending negative externalities may be particularly bad for baseline mood. • Lack of knowledge of baseline mood production fn. • The relative price of baseline mood may be trending up. (A large effect if the elasticity of substitution between baseline mood and other goods is high.)