Optimal Irrational Behavior

Contrary to the usual presumption that welfare is maximized if consumers behave rationally, we show in a two-period overlapping generations model that there always exists a rule of thumb that can weakly improve upon the lifecycle/permanent-income rule in general equilibrium with irrational households. The market-clearing mechanism introduces a pecuniary externality that individual rational households do not consider when making decisions, but a publically shared rule of thumb can exploit this effect. For typical calibrations, the improvement of the welfare of irrational households is robust to the introduction of rational agents. Generalizing to a more realistic lifecycle model, we find in particular that the Save More Tomorrow Plan can confer higher lifetime utility than the permanent-income rule in general equilibrium.