Cognitive Economics Definition Taking seriously data other than

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. 1

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

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

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: theoretical status of happiness is unclear. 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

What is “Happiness” in Relation to Economic Theory? a. Flow utility? b. The individual’s overall objective function? c. The part of the individual’s objective function that abstracts from the desire to do one’s duty? d. The individual’s objective function plus pleasure from memory? e. None of the above. 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

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

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. 9

B. Judging Individual Welfare • People’s own choices and feelings are the two nonpaternalistic indicators we have for individual welfare (what makes an individual better off in the sense relevant for policy). • A priori, both seem useful. 10

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. 11

D. The Relationship Between Happiness and Utility is Unresolved Existing work in Economics largely either A. B. ignores happiness data, e. g. : “Happiness is irrelevant to Economics” OR assumes happiness=flow utility: “Happiness is a sufficient statistic for utility. ” 12

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. 13

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. • The nature of the relationship between the standard psychological concept of happiness (affect) and the standard economic concept of lifetime utility is an open empirical question. 14

Significance Establishing any systematic relationship between affect and utility would 1. provide an important bridge between psychology and economics. 2. allow psychological data and theory to be used in economics in a way that is complementary to standard economic data and theory. 3. allow all the tools of economics to be brought to bear toward understanding 15 happiness.

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

The Easterlin Paradox 17

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” 18

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. ) 19

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. 20

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

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 22

6. Integrated Theory of Utility and Happiness happiness= 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 23

News and Happiness • 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

‘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 → 27

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 on the same things with different weights) – has a complex household production function (or 28

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 29

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. 30

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. 31

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. ) 32

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 … 33

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

Theory of Happiness (Current Affect) 35

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. 36

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 the MLR order in every future date and state of nature, then the agent will strictly prefer rule A. 37

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. 38

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). 39

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. 40

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

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

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. 43

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. 44

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) 45

The Evolutionary Psychology of Elation and Dismay • Functionally, elation and dismay 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. 46

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). 47

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. 48

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. 49

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 50

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. 51

Why are Utility and Happiness Confused? (continued) • Elation and dismay 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. 52

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)) +b 0ιt+b 1ιt-1+b 2ιt-2+… c. or flow utility = U(Kt, Xt, M(Kt, Xt), e(ιt, ιt-1, ιt-2, …)) ) 53

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. 54

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”) 55

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. 56

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. 57

9. Implications for Happiness Empirics • The time series properties of happiness matter. • Price Theory can be used to study baseline mood (e. g. , value of happiness). • The Elation Theory is readily testable. • Elation provides information about preferences and expectations. – Like event studies in Finance – Need high frequency data on affect. 58

10. Implications for Policy • Happiness is valuable: should be fostered. • Happiness data are a reminder of tangible and intangible externalities in the utility function—especially social rank externalities. • Economic growth is of enormous value, despite the Easterlin Paradox. • Happiness data is not enough to diagnose optimization mistakes. 59

Reprise: Integrated Theory of Utility and 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. ) 60

Conclusion: Integrating Happiness into Mainstream Economics • Happiness needs to be integrated in a way that respects the canons of Economics. • Two key dimensions for integrating happiness into economics: – First, the short-run responses of happiness to news provide important information about preferences. – Second, long-run happiness is important in its own right. 61

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. 62

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: 1. Much of the time during the past week, you felt you were happy. (Would you say yes or no)? 2. (Much of the time during the past week, ) you felt sad. (Would you say yes or no? ) 3. (Much of the time during the past week, ) you enjoyed life. (Would you say yes or no? ) 4. (Much of the time during the past week, ) you felt depressed. (Would you say yes or no? )” 63

The Validity of Self-Reported Happiness Correlated with • observer ratings of happiness • structured coding of facial expressions • electrical measures of face muscle activation • voice tone • skin conductance, heart rate, blood pressure, etc. • writing speed • judgment of probabilities • word association and word completion • startle reflex • left pre-frontal cortex activity (which can also be induced by seeing pictures of a smiling baby and reduced by seeing pictures of a deformed baby) 64

Other Measures of Subjective Well. Being: Life Satisfaction On a scale from 1 to 10, how satisfied are you with your life? 65

World Values Survey Global Happiness Question "Taking all things together, would you say you are 1. Very happy 2. Quite happy 3. Not very happy 4. Not at all happy 9. Don’t Know [Do NOT READ OUT]” 66

Problems with these Alternative Measures of Subjective Well-Being • • 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. 67

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 lifesatisfaction or global happiness questions anyway. It is clearer to focus on that current happiness component directly. Then we know what we are getting. 68

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. 69

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. 70

Life Expectancy 71

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 72

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. 73

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. 74

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. 75

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. 76

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. 77

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 1. has no strong trend. 2. is strongly mean-reverting. 78

The Easterlin Paradox 79

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” 80

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 81

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. 82

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. 83

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 84 functional form.

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? (cf. John Rawls) – Beware of nostalgia. – Remember the problems that have now been partly or wholly resolved. – Hold relative social rank constant. – Think about relative mortality rates. 85

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? 86

Utility≠Happiness Summary of the Argument a. If only innovations in lifetime utility mattered for happiness, maximizing happiness and maximizing lifetime utility would be equivalent. b. Focusing on only changes leaves out Rawlsian preferences. c. Any predictable effect of choice variables on happiness implies innovations in lifetime utility are not the only component of happiness. d. People who knowingly, thoughtfully and without regret choose not to maximize long-run happiness indicate that utility≠happiness for them. 87