Boundedly Rational Dynamic Programming: Some Preliminary Results
A key open question in economics is the practical, portable modeling of bounded rationality. In this short note, I report ongoing progress that is more fully developed elsewhere. I present some results from a new model in which the decision-maker builds a simplified representation of the world. The model allows to model boundedly rational dynamic programming in a parsimonious and quite tractable way. I illustrate the approach via a boundedly rational version of the consumption-saving life cycle problem. The consumer can pay attention to the variables such as the interest rate and his income, or replace them, in his mental model, by their average values. Endogenously, the consumer pays little attention to interest rate but pays keen attention to his income. One consequence of this is that Euler equations will be biased, and the intertemporal elasticity of substitution will be biased toward 0, in a manner that is quantitatively important.
I thank David Laibson for a great many conversations about bounded rationality. For useful comments I also thank seminar participants at the AEA meetings, Chicago, U. Penn, and Yale. This note summarizes some elements of Gabaix (2011, 2012), which remain the primary references for this research. The views expressed herein are those of the author and do not necessarily reflect the views of the National Bureau of Economic Research.