Lecture12: Bounded Rationality

Today's subject was another type of economic psychological theory; bounded rationality. For bounded recall, the teacher told us relation of memory in Prisoners’ Dilemma, Tid-for-tat strategy, indirect reciprocity. As for Self-serving bias, he mentioned about some experiments and field study. Finally, he treated Time Inconsistency using three period models. What was interesting for me was he mentioned about similarity between economics and biology in the argument of “organization”. That was exactly what I thought!

Bounded recall:
This is a supplement of memory for game because memory is important for institutional solution to incentive problems. In fact, in the repeated two-player prisoners’ dilemma, needed memory is only one period.

Example: Sequential Prisoners’ Dilemma
Player: 1 and 2
Rules: choose C or D, repeatedly
Payoff: U(C,C) U(C,D) U(D,C) U(D,D)
Outcome: U(C,C)=a U(C,D)=b U(D,C)=c U(D,D)=d
C=cooperates, D=defets

Strategies:
Tit-for-tat(TFT): do always others do
TFT is stable when δ is sufficiently large, but it is vulnerable if there is some mistakes to choose. A better strategy is forgiving TFT. Even better is WSLS(Win-Stay Lose-Shift). This means first one sets a target of his payoff, and if the payoff is higher than the target, he stays. Otherwise, he change. If constant positive probability another round isδ>a/b, it is ESS(Evolutionary Stable
Strategy; the strategy to reach maximization without other hypothesis, and Nash equilibrium that can explain social evolution.)

Indirect Reciprocity:
When players switch partners often, with reputation across interactions, cooperation is sustainable. To consider (i) cooperate unless the opponent is known defector, (ii) always defect, necessary condition for cooperation in equilibrium is q>a/b). but of course, one-period memory of actions does not quite suffice because we do not see types, only behaviors.

The justification of government:
According to David Hume, the reasons for needs of government are:
(i) People do not have impartial view
(ii) People cannot plan for long time
(iii) There are public goods

Self-serving Bias:
Agents may have self-serving interpretations of fairness.

Tort Case Experiment:
Self-biased leads disagreement, and if they know each other the rate of impasses become smaller.

A field study:
Public school teacher’s negotiation.
Both employers and teachers use wages in comparison districts as argument, but the comparison is biased. Incidence of strikes is related difference in comparison group. A solution is to add some teacher to board, or to adapt job rotation.

Time inconsistency:
Even a single person may have problems making credible commitments to herself:
The reason for prohibitions is for the merit of a person who wants to do such things.

Time inconsistent model:
U=u(c0)+βΣδu(ct) (if δ<1, the agent is time inconsistent. And δ=1, it is the same as conventional model: U=Σδu(ct))

If taken three period model, Utility is
U= In c1 + βδInc2 +βδ2Inc3
Total income is Y. Suppose interest rate is zero, then
C1+c2+c3-Y=0

Case(i); Full Commitment
Optimization through three period
Case(ii): No Commitment
Consider c3*=Y-c1-c2, c2+c3=Y-c1, and solve c1* to maximize period 1.

If there is no commitment, consumption is higher in Period 2 and lower in Period 3. and if the agents cannot commit, he is worse off. Suppose if politician propose a compulsory pension scheme forcing people to consume less in period 2 and more in period 3. Politician will be elected because they want someone to force them save money for period 3.

Another implications:
1. Why people save illiquid assets:
People want something force them to save money
2. Why they borrow and save simultaneously
People want something force them to save money
3. Why consumption drops heavily at retirement
People views spot time utility optimization
4. Why people agree to ban drugs and prostitution
People thinks it is good for themselves even if they want to do so.
5. Xenical and Antabus
People want to diet or be healthy even if they do not try

Dual Process Mind?
Ambiguity aversion and loss aversion.
There are two ways to decide: instinctive and cognitive
Analyzing dual-self model: long-run/short-run self: period 1 is much and 2 and 3 is less.