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Behavioral and Policy Implications of Rational Inattention

Periodic Reporting for period 2 - INATTENTION (Behavioral and Policy Implications of Rational Inattention)

Reporting period: 2017-10-01 to 2019-03-31

My goal is: to improve our understanding of naturally emerging as well as optimal policies in environment with cognitively limited human beings.
• How do economic agents with limited attention behave and respond to incentives?
• What policies best fit the needs of such agents, and what policies in fact emerge in this environment?
• Provide direct empirical evidence on what drives decisions of attention in the field.

I seek to achieve this because:
• There is evidence that attention frictions are significant, and lead to poor choices.
• Neglecting the friction leads to misguided policy implications, and thus the inattention angle has the potential to yield large benefits.
• Theoretical findings tend to be incorporated into real policies by rules of thumb, with preference for simplicity, and offering policy prescriptions based on rational inattention could change that practice.

If the project is successful, it will:
• Deepen our understanding of how economic agents perceive complex environments, and lay methodological foundations for research in several areas.
• Provide guidelines for policy design and highlight policies better compatible with cognitively limited human beings. What is the optimal level of simplicity of tax policy? Which form should automatic saving plans take? Which democratic processes function well despite voters’ inattention?

The agenda is specifically targeted at applications where human inability to digest all available information has strong implications for public policy formation. It falls into three broad parts.

First (macroeconomics), the proposed research will develop a new model of risk-sharing in a typical modern-macro setting with heterogeneous agents. Hayek (1945), in his seminal work, defended free markets over central planning on the grounds of the government’s inability to obtain all information about supply and demand, some of which is in principle available to the government as much as to any of the competing firms. If we agree with Hayek’s argument, then it also seems to be an important idea to introduce such frictions to our market-based models, where the government still has a role to play in redistribution, for instance.

Second (behavioral economics). One of the first and most important observations in behavioral economics has been mental accounting, e.g. Thaler (1980,1999). Consumers do not use one global budget for different types of expenditures. Expenditures are segregated into categories (housing, entertainment, food, etc.), and spending within each category is constrained by a budget. Money in one account is not a perfect substitute for money in another. These findings are in disagreement with what the standard consumption theory suggests, and they are important since they affect central economic decisions such as consumption and investment choices. Moreover, they play a particularly important role when the quality of these decisions matters the most, which is for the very poorest people (Thaler 1980, Zelizer 1996).
What is the connection to rational inattention? According to Thaler (1999), mental accounts, just like standard business accounts, are systems to record and summarize transactions. They are a way of aggregating and summarizing large amounts of data to facilitate good decision making by reducing the information the decision maker has to look at. However, the existing theories of mental accounting that Thaler and others developed are not directly based on the inability to process and record information, and thus they are likely to have different implications. This project aims at building the theory of mental accounting directly on the idea that digesting large amounts of data is not costless for people, i.e. in line with Thaler’s ideas.

Third (political economy), it will develop a unified framework to study implications of voters’ rational inattention (selective ignorance) for the outcomes of political processes, such as fo
So far, we have worked mostly on part 2 (behavioral economics) and part 3 (political economy). The main results are working papers

1) Botond Koszegi and Filip Matejka: An Attention-based Theory of Mental Accounting,

In this paper, we develop a theory of mental accounting based on the idea that individuals find it too costly to think through all relevant information for making consumption choices, and therefore they pick and choose what information to pay attention to. When deciding how to allocate her budget between different consumption goods, the agent finds it most useful to think about which of multiple substitutable goods to consume, and less useful to think about how to trade o dissimilar goods. As a result, she behaves as if she had a mental account for the most substitutable goods, with the breadth of her account being determined endogenously by her preferences and attention costs. When managing her lower-interest checking account and higher-interest savings account, the agent finds it more useful to pay attention to her checking-account balance, as she would like to balance this account and transfer as much as possible to the savings account. As a result, her consumption is more responsive to the checking-account balance than to the savings-account balance, and this difference is more pronounced when the interest-rate differential between the accounts is higher. And when the agent receives a targeted transfer such as a child benet, she finds it more worthwhile to think about whether a high level of targeted consumption is valuable, and as a result consumes more on average.

2) Filip Matejka and Guido Tabellini: Electoral Competition with Rationally Inattentive voters,

This paper studies how voters' selective ignorance interacts with policy design by political candidates. It shows that the selectivity empowers voters with extreme preferences and small groups, divisive issues attract most attention and public goods are underfunded. Finer granularity of information increases these inefficiencies. Rational inattention can also explain why competing candidates do not always converge on the same policy issues, and how the poor are politically empowered by welfare programs.
We expect to make progress on the Part 1 (macroeconomics), and push empirical results using a field experiment on Part 3, too.