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 “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.

7. The Standard View in Psychology • Currently, the standard view among psychologists and most economists working with happiness data—articulated most forcefully by Daniel Kahneman—is that a present discounted value of measured happiness is a good indicator of what people should be maximizing. • To the extent that people are maximizing something else, it is viewed as a mistake. • Factual mistakes people make in predicting their own future happiness are thought to be an important reason people make these optimization mistakes.

8. Our View • We are questioning this orthodoxy. • When well-informed and thoughtful, we view people’s choices as the best indication of their individual welfare. • People do often make optimization errors. • But much of what this orthodoxy takes as evidence of optimization errors, we take as evidence that utility and “happiness” are not the same thing.

9. 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?

10. Our Answer • Part of happiness is a temporary response to changes in utility or news about utility. • Handled with care, these bursts of happiness give useful information about overall utility. • The more persistent, predictable part of happiness is a valuable commodity like health, but is not a measure of overall utility. • People care about how they feel, but it is not the only thing they care about. • Because people care about how they feel, having more knowledge about how to feel happy is extremely valuable. Many of the policy issues about happiness are the issues that always arise in relation to valuable knowledge. • If people care about how they feel, so that happiness is in the utility function, policy issues also arise when any externality affects happiness.

11. 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.

12. 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.

13. 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.

14. 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.

15. 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.”

16. 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.

17. 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.

18. 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.

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. 3.Psychologists Reliably Measure Happiness, But What Is It? • Some economists think happiness can’t be measured well. This is just not true. Current happiness (affect) is one of the easiest of all subjective concepts to measure. • What is true (that these economists are intuiting) is that once happiness is measured, we don’t know what it means in terms of economic theory.

24. Measuring Current Happiness (‘Affect’). “Now think about the past week and the feelings you have experienced. Please tell me if each of the following was true for you much of the time this past week: • Much of the time during the past week, you felt you were happy. (Would you say yes or no)? • (Much of the time during the past week,) you felt sad. (Would you say yes or no?) • (Much of the time during the past week,) you enjoyed life. (Would you say yes or no?) • (Much of the time during the past week,) you felt depressed. (Would you say yes or no?)”

25. The Validity of Self-Reported Happiness Correlated with • frequency of smiling. • others’ ratings of how happy someone is. • social rank. • high activity in the left pre-frontal cortex and low activity in the right pre-frontal cortex--which can also be induced by seeing pictures of a smiling baby and reduced by seeing pictures of a deformed baby.

26. Other Measures of Subjective Well-Being: Life Satisfaction On a scale from 1 to 10, how satisfied are you with your life?

27. World Values Survey Global Happiness Question "Taking all things together, would you say you are • Very happy • Quite happy • Not very happy • Not at all happy 9. Don’t Know [Do NOT READ OUT]”

28. Judging overall life-satisfaction or overall happiness in life is a complex cognitive task. Evidence on the sensitivity of of subjective well-being data to context indicates that respondents use shortcuts involving readily accessible information, such as How happy the respondent feels right now How happy the respondent thinks he or she should feel, given objective circumstances. Problems with these Alternative Measures of Subjective Well-Being

29. Advantages of Affect Measures (Current Happiness Measures) • By contrast, affect measures depend on much more accessible information: • How R feels right now. • How R felt the past week. • Very little judgment is required. • How R feels right now affects the overall life-satisfaction or global happiness questions anyway. It is clearer to focus on that current happiness component directly. Then we know what we are getting.

30. 4. Measuring Utility: Revealed Preference Over Choices • The Ordinalist, or “revealed preference” revolution in Economics developed techniques for measuring individual welfare based on choice data alone. • This clearly defines utility as a distinct concept from happiness. • Utility is the extent to which people get what they want. • Happiness is how people feel.

31. The Trend in Utility:Choose between 1955 and 2005 • The electronics revolution and the Internet have vastly expanded access to a rapidly growing quantity of culture and science. • Crime, teenage pregnancy and drug abuse worsened at first but now trend downward. • Greater equality between races and sexes. • War on Terror better than Cold War. • Better medical care and greater longevity.

32. Life Expectancy

33. Would you want to go back to the way things used to be? • No computers or electronics • No Ben and Jerry’s • No Harry Potter • No Beatles music yet released • Jim Crow, strong male dominance • Cold War • Few modern drugs

34. Revealed Preference: Migration Flows • Per capita GDP in Mexico is not far from what it was in the U.S. in the 1950’s. • Large numbers of Mexicans choose to migrate to the U.S. • Among the many costs of migration, their social rank often drops drastically when they migrate to the U.S. Despite this, they come.

35. Do People Know Their Own Utility Functions? • Not perfectly. For example, I don’t know if I will like a new flavor of ice cream. • Lack of knowledge of one’s own utility function can be modeled as an internal informational constraint. (Rayo-Becker is an example.) • The key distinguishing features of mistakes about one’s own utility function are • regret • changing one’s mind after learning more.

36. Can Happiness Data Alone Diagnose Optimization Mistakes? • No. Happiness data alone cannot diagnose a mistake without strong assumptions about the relationship between utility and happiness. • Even the relevance of mistakes in predicting future happiness depends on the relationship between happiness and utility. • In Section 8 C, we illustrate how people could make mistakes in the impulse response pattern of future happiness without impairing optimization at all.

37. 5. Happiness ≠ Flow Utility: Evidence • Assuming that current happiness is equal to flow utility immediately has many strong implications. • In particular, a large amount of data on happiness exists, with many characteristics that do not match usual ideas about utility. • Measured happiness • has no strong trend. • is strongly mean-reverting.

38. The Easterlin Paradox

39. 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.

40. Experience Data Show Even Stronger Hedonic Adaptation • Data on felt happiness from experience sampling reverts to its previous level even more completely than life satisfaction and global happiness assessments (Kahneman and Schwarz, unpublished work). Why? • Life satisfaction and global happiness assessments incorporate • an element of autobiography • people’s ideas about how they “should” feel

41. Hedonic Adaptation is Not the Same Thing as Habit Formation • Hedonic adaptation is a statement about happiness, as measured by psychologists. • Habit formation is a statement about utility, as measured by economists. • If happiness were equal to flow utility, data on hedonic adaptation would imply very strong habit formation.

42. Evidence on Habit Formation Constantinides Form: 1. Joseph Lupton estimates θ≈.75 based on portfolio choices 2. Impulse responses for consumption choices suggest θ close to zero unless the lags in the habit H are very long. 3. Because of the speed of hedonic adaptation, long lags are inconsistent with U=Affect.

43. Modeling Choice: Habit Formation or Just Hedonic Adaptation? Suppose and 1. Equivalent to and happiness=first difference of flow utility. 2. Let’s keep the economic theory simple and put the complexity in the utility-happiness relationship. a. It’s clearer and simpler. b. It avoids the misleading impression that there is anything wrong with the more traditional functional form.

44. Does Habit Formation Affect the Choice between 1955 and 2005? • To include the effects of habit formation on the decision, imagine you had to give your newborn, whom you care a lot about, up for adoption. Which world you would want your newborn to grow up in? • Beware of nostalgia. • Remember the problems that have now been partly or wholly resolved. • Hold relative social rank constant. • Think about relative mortality rates.

45. Other Evidence that Utility≠Happiness 1. People make choices eagerly that they never regret, but which have no long-run effect on their affect. • Moving to a new city • Buying a nice car 2. With some misgivings at the tradeoff, people thoughtfully make choices that they never regret, which lower their affect. • Commuting further to a higher-paying job. • Longer working hours to put one’s child through college. • Having a baby?

46. 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

47. 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.

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

49. 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.

50. ‘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 →