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. 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.

5. “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?

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. What “happiness” (subjective well-being) is NOT • NOT utility. • NOT happiness in Aristotle’s sense (recommended preferences). • But, we argue, this kind of data carries useful information.

8. Outline of Introduction • Distinguishing utility and happiness as a matter of logic. • Why we care about utility and happiness. • Why the relationship between them can’t be simple (short version). • Our take on the relationship between utility and happiness.

9. A. “Utility” and “Happiness” • 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.

10. B. Judging Individual Welfare • 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.

11. C. The Easterlin Paradox and Hedonic Adaptation Taking both feelings and choices seriously runs into the difficulty that affect and utility seem to behave quite differently. • Easterlin Paradox: Measured utility trends strongly upwards, while measured happiness has little trend. • Hedonic Adaptation: Utility is affected permanently by permanent changes in external circumstances, but the effects on happiness seem shorter-lived.

12. D. The Relationship Between Happiness and Utility is Unresolved 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.”

13. 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.

14. The Question: What is the Relationship? • Both felt happiness and choice-based utility are well-defined, observable concepts. It is easy to resolve many seeming paradoxes when one recognizes that these are two different things. • Thenature of the relationship between the standard psychological concept of happiness (affect) and the standard economic concept of lifetime utility is an open empirical question.

15. Significance Establishing any systematic relationship between affect and utility 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.

16. Empirical Facts Motivating our Theory of Happiness • Easterlin Paradox • Hedonic Adaptation

17. The Easterlin Paradox

18. 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”

19. 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 a subutility function (like health, entertainment, or nutrition.)

20. Why Happiness Matters for Economics (Our View) • First, short-run happiness in response to news can give important information about preferences. • Second, long-run happiness is important for economic welfare in the same way as other composite goods such as health, entertainment, or nutrition.

21. The Core of the Paper 3. Measuring Happiness 4. Measuring Utility 5. Utility ≠ Happiness: Evidence 6. An Integrated Theory of Utility and Happiness

22. Bonus Features 7. Why Utility and Happiness are Often Confused 8. Elation in the Utility Function 9. Implications for Happiness Empirics 10. Implications for Policy

23. 6. Integrated Theory of Utility and Happinesshappiness= baseline mood + elation. A. Elation B. Baseline Mood C. Formal Model D. Expectations and Happiness E-G. Evolutionary Significance -Elation -Hedonic Adaptation -Baseline Mood H. Implications of the Integrated Theory

24. 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.

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

26. 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.

27. ‘Baseline Mood’ • baseline mood = M(Kt, Xt) • Xt= vector of control variables: time use, spending pattern, portfolio choice, etc. • Kt = vector of • state variables encoding every aspect of the past that matters for utility: wealth, weight, habits, level of fatigue, one’s spouse being alive, etc. • variables exogenous to the individual: weather, state of macroeconomy, consumption patterns of others in society, etc. CONTINUED ON NEXT SLIDE →

28. Baseline Mood and Flow Utility • flow utility = U(Kt, Xt, M(Kt, Xt)) • We think of baseline mood M(Kt, Xt) as the component of happiness produced by a household production function. • A good analogy is to 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

29. 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

30. 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.

31. 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.

32. 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.)

33. Formal Model of Utility and Happiness vt = lifetime utility U =flow utility M =baseline mood Et= rational expectation as of time t β = impatience Kt = state vector: wealth, weight, fatigue, being alive, spouse being alive, genes, weather, prices, tax rates, pollution average level of consumption in society… Xt = control vector: consumption, time use …

34. The Innovation in Lifetime Utility and Elation Note about the lifetime utility innovation:

35. Theory of Happiness (Current Affect)

36. Preference for Happiness Axiom: Informal Version • 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.

37. Preference for Happiness Axiom Suppose that before the arrival of some information, an agent is indifferent between two decision rules A and B. If information arrives that has no effect on the feasible set of choices of K and X, but which raises the probability distribution of happiness under rule A and lowers that under B according to first-order stochastic dominance in every future date and state of nature, then the agent will strictly prefer rule A.

38. 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.

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

40. Preference for Happiness: Discussion • Preference for Happiness has important implications, but is a cautious assumption. • Cautious assumptions have the advantage of being more likely to gain broad acceptance within Economics.

41. The Happiness and News Axioms • Happiness is a function of the history of K, X and lifetime utility. Fixing the realized history of K and X, b. Happierif currentexpected lifetime utility is of a preferred future. c. Less happy if past expected lifetime utility was of a preferred future.

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

43. 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) 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.

44. Neurobiological Evidence that Expectations Matter for Affect • “These studies measured the firing of dopamine neurons in the animal’s ventral striatum, which is known to play a powerful role in motivation and action. • In their paradigm, a tone was sounded, and two seconds later a juice reward was squirted into the monkey’s mouth. • Initially, the neurons did not fire until the juice was delivered.

45. Neurobiological Evidence that Expectations Matter for Affect • Once the animal learned that the tone forecasted the arrival of juice two seconds later, however, the same neurons fired at the sound of the tone, but did not fire when the juice reward arrived. • These neurons were not responding to reward, or its absence … they were responding to deviations from expectations. • When the juice was expected from the tone, but was not delivered, the neurons fired at a very low rate, as if expressing disappointment.” (p.26)

46. The Evolutionary Psychology of Elation and Dismay • Functionally, elation and dismay may motivate cognitive processing—much like curiosity. • Elation: after good news, it pays to • think what you did right, so you can do it again • think how to take advantage of the new opportunities • Dismay: after bad news, it pays to • think what you did wrong, so you can avoid doing it again • think how to mitigate the harm of the bad news • Curiosity: after news that is neither clearly good nor bad, it pays to learn more for the sake of option value • Economic implications of this functional role of elation: such directed information acquisition could affect probability assessments in systematic ways.

47. The Evolutionary Psychology of Hedonic Adaptation • “Adaptive processes serve two important functions. First, they protect organisms by reducing the internal impact of external stimuli…. Second, they enhance perception by heightening the signal value of changes from the baseline level….” • “Hedonic adaptation may serve similar protective and perception-enhancing functions…. persistent strong hedonic states (for example, fear or stress) can have destructive physiological concomitants … Thus, hedonic adaptation may help to protect us from these effects.” • “Hedonic adaptation may also increase our sensitivity to, and motivation to make, local changes in our objective circumstances….” (Frederick and Loewenstein) • See also Rayo and Becker (2005).

48. Speculations on The Evolutionary Psychology of Baseline Mood • High social rank may make it safe to look more for opportunities than for dangers, so that it makes sense to stimulate the same machinery that is turned on by the receipt of good news. • Frequency dependence in the value of being an optimist or pessimist. • Quirks in the system? • Stephen Pinker’s view of cheesecake.

49. Three Implications of this Theory of Happiness • Happiness ≠ Utility. • Disputes the idea that temporary movements in affect are unimportant: a temporary movement in affect can signal important utility-relevant news related to the long-term welfare of the individual. • Baseline mood is not a summary measure of utility, but it is something people care about.

50. Bonus Features 7. Why Utility and Happiness are Often Confused 8. Elation in the Utility Function 9. Implications for Happiness Empirics 10. Implications for Policy