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The effect of unemployment on saving: an experimental analysis

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 The Effect of Unemployment on Saving
An Experimental Analysis1

Enrica Carbone
University of York and Università del Sannio

John D. Hey
University of York and Università di Bari

Abstract
This paper analyses whether individuals correctly take into account their employment
status when taking savings and consumption decisions in a life-cycle context. We
implement an experimental investigation which differs from previous studies in that it
incorporates the empirically relevant fact that employment status follows
(approximately) a first-order Markov process. We find that subjects (in varying
degrees) have difficulty in fully optimising their decision process, and instead appear
to operate using a ‘working horizon’ which they roll forward through time. As a
consequence actual behaviour departs significantly from optimal, and, in particular,
subjects over-react to their employment status – under-consuming when unemployed
and over-consuming when employed. Moreover they seem to have difficulty in
understanding the probabilistic structure of the employment process. This would seem
to give good reasons for state intervention in the unemployment insurance process.
However, while behaviour departs from optimal in an absolute sense, the (qualitative)
comparative static propositions of the optimal theory seem to be validated – even
though the magnitude of the responses are sometimes far from optimal.

Keywords: consumption and saving, decision under risk, intertemporal choice,

experimental methods.

JEL classifications: C91, D91.

Corresponding address: John D. Hey: Department of Economics, University of York,

York YO1 5DD, UK.

e-mail addresses: ecarbone@unina.it (Carbone) and jdh1@york.ac.uk (Hey)

1
We would like to acknowledge financial support from the European Commission under the TMR
grant “Savings and Pensions”. We would also like to thank participants at the TMR conference held in
Tilburg in March 1999, the participants to FUR IX held in Marrakech in June 1999, the participants in
the IAREP conference in Belgirate in Jun-July 1999 and participants in the meeting of the “Gruppo di
Studio per le Teorie e Politiche Economiche in Benevento in October 1999.
 The Effect of Unemployment on Saving
An Experimental Analysis

Enrica Carbone
University of York and Università del Sannio

John D. Hey
University of York and Università di Bari

1 Introduction

The purpose of this paper is to investigate whether people correctly take into

account their employment status when deciding their consumption and saving. This

issue is important for a number of reasons, not least for the optimal design of state

unemployment insurance systems.

In particular, the paper reports on the results of an experiment which enables

us to investigate how consumption and saving decisions depend upon uncertainty

about employment and upon the employment status itself. The probability of being

unemployed, and more precisely the dependence of this on the current employment

status, should have an effect on saving (especially the precautionary component). We

test a version of the life-cycle model in which the states of being employed or

unemployed follow a first-order Markov process. This means that the probability of

being employed in any period depends upon the employment status in the

immediately preceding period. The theory tested is described in section 2 - beginning

with an introduction to the basic life-cycle theory and then describing the particular

case of this general model investigated in the experiment reported in this paper.

Section 3 describes this experiment - beginning in sub-section 3.1 with a discussion of

how the life cycle problem can be implemented in the laboratory, and then providing

a description of the software used. Sub-section 3.2 reports on the choice of the

2
parameters used in the experiment, while sub-section 3.3 describes how the

experiment was implemented in the EXEC lab in York, Finally sub-section 3.4

outlines the main differences with previous work done in this area, particularly the

papers by Hey and Dardanoni (1988) and Ballinger et al (2001). The analyses of the

results are reported in section 4. We start in sub-section 4.1 with a comparison of the

estimated actual consumption strategy with the optimal consumption strategy, and

note that there are sizable differences. In the light of this we then look in sub-section

4.2 at the differences between actual and optimal behaviour, trying to find out which

of the variables explain this difference. It is clear that the theory does not do

particularly well at describing the behaviour of the subjects. However, it may be the

case that, although their behaviour in an absolute sense is not consistent with the

theory, the comparative static predictions of that theory may be correct. Accordingly

we present in sub-section 4.3 various tests of the comparative static predictions of the

optimal theory. It appears some of the comparative static predictions of the theory are

confirmed – even though subjects generally are not behaving optimally. In the light

of this latter result we try, in section 4.4, to discover what it is that the subjects are

actually doing. We assume that the subjects are not able to optimise fully but instead

adopt a ‘planning horizon’ (shorter than the true horizon) and then try and optimise

with respect to that. We estimate these ‘planning horizons’ of the subjects, and

discover that there is considerable variation. Some subjects are able to plan many

periods ahead, while others can plan only a very few periods ahead. The implications

are important – particularly for the state provision of unemployment insurance. In

particular, the question is raised: should the state plan ahead for those people who are

unable to do so themselves? We discuss this and other conclusions in section 5.

3
2 Theory

We begin, in sub-section 2.1, with a general formulation of the Life-Cycle model

of consumption and saving, and then turn, in sub-section 2.2, to the particular

specification which forms the basis for the experimental investigation reported in this

paper.

2.1 The Life-Cycle model in general.

We consider a standard Life-Cycle model of consumption. That is, we

consider the decision problem of an individual, who lives a discrete number (possibly

finite, infinite or random) of periods, in each of which he or she must decide how

much to consume and how much to save. It is assumed that this individual obtains

utility from consumption in each period of his or her lifetime and that lifetime utility

is simply the discounted sum of the utilities obtained in each period. That is, we

assume that the preferences of the individual are as given by the Discounted Utility

model. We denote the periods by t = 1,2,…, T (where T may be finite, infinite or

random) and we denote income and consumption in period t by Yt and Ct respectively.

Further, we denote the per-period utility-of-consumption function by U(.) and we

assume for simplicity that this is time invariant. Given our assumptions about the

individual’s life-cycle preferences, this means that we can state the individual’s

objective, as viewed from period t, as the maximisation of (in an uncertain world, the

expected value of) the following expression:

U(Ct)+DU(Ct+1)+…..+ DT-tU(CT) (1)

this, of course, representing the discounted lifetime utility as viewed from period t,

where D is the individual’s constant discount factor.

4
 Let us now introduce some further notation. We denote the individual’s

wealth at the beginning of period t by Wt, and we denote by r the rate of return on

wealth, that is, the rate of interest plus 1. We assume that r is constant and we further

assume that the individual can freely borrow and save at this constant rate of interest,

subject to any constraints on such borrowing and saving which may exist. We assume

that income in period t, Yt, is known by the individual before he or she chooses

consumption Ct (and hence saving) in that period. This gives us the intertemporal

budget constraint:

Wt+1=r(Wt - Ct) + Yt+1 (2)

In a risky world future incomes will be risky. However, we assume that the

individual knows the probability distribution of all future incomes and, of course, all

other relevant parameters (r and D) and the function U(.). We denote all this

information as viewed from period t, by the information set Ù t.

The decision problem of the individual can now be specified: through time

the individual wishes to determine a consumption stream (and hence a saving stream)

which maximises the expression (1) for all time periods t. The solution can also be

specified in the following way. We introduce maximal value functions Vt(.|Ùt) which

measure the maximised expected value of the objective function (1) as viewed from

the beginning of period t with information given by the information set Ùt. Clearly

these maximal value functions are functions of wealth at the beginning of period t and

are defined by:

Vt(Wt| Ù t) = max E [U(Ct)+DU(Ct+1)+…..+ DT-1U(CT) (3)

where the expectation is taken with respect to the information set Ù t and where the

maximisation is carried out with respect to the choice of consumption Ct in period t.

5
Ù We can now use the definition of Vt+1(.|Ù t+1) to replace all except the first term

on the right hand side of equation (3) to give us the following basic recursive

equation:

Vt(Wt| Ù t) = max [U(Ct)+D E Vt+1(Wt+1| Ù t+1)] (4)

where Wt+1 is given by (2), where the expectation is taken with respect to the

information set Ùt and where the maximisation is carried out with respect to the

choice of consumption Ct in period t.

In principle, the individual’s problem is now solved: the optimal consumption

in period t is simply the value of Ct which maximises the term in square brackets on

the right-hand-side of equation (4). Substituting this back into equation (4) enables

the function Vt(.|Ùt) to be derived from the function Vt+1(.|Ù t+1). The recursion starts

in the final period, period T, when, clearly VT(WT| ÙT) = U(WT) for all WT . Hence,

working backwards we can find recursively all the Vt(.|Ùt) functions and the optimal

consumption levels in all periods. Note that the latter is obviously a function of

wealth, Wt, at the beginning of period t as well as the information set Ùt. We say ‘in

principle’ deliberately – since the above ‘solution’ does not actually provide specific

advice to the individual as to what to consume each period. To implement the

solution, the individual first needs to solve for the optimal consumption strategies as

functions of Wt and Ùt for every period t and at the same time to solve for the

functions Vt(.|Ùt) for every period t. Only having done this can the individual actually

implement the optimal strategy. However, the actual computation of these optimal

functions is difficult in general.

We simplify the problem by considering a special case of this general life-

cycle model. This we discuss in the next sub-section.

6
2.2 A particular formulation of the general Life-Cycle model.

We examine a particular case of this general model. Our primary interest is in

the response of individuals to changes in their employment status. Accordingly we

adopt a particularly simple form in which future incomes can take one of two possible

values – a high value, which we denote by Y, which corresponds to employment, and a

low value, which we denote by Z, which corresponds to unemployment. Moreover, to

capture the empirically relevant fact that future employment status is dependent on

present employment status, we assume that the income generating process through

time is a first-order Markov process. More precisely, we assume that if the individual

is employed in period t (that is, has income Y in period t) then the probability that the

individual remains employed in period t+1 (that is, has income Y in period t+1) is p,

whereas the probability that the individual becomes unemployed in period t+1 (that

is, has income Z in period t+1) is (1-p). Contrariwise, we assume that if the

individual is unemployed in period t (that is, has income Z in period t) then the

probability that the individual remains unemployed in period t+1 (that is, has income

Z in period t+1) is 1-q, whereas the probability that the individual becomes employed

in period t+1 (that is, has income Y in period t+1) is q. This kind of first-order

Markov process appears to be a good approximation of empirical facts.

We now assume that everything else remains constant through time. In

particular we assume that the employed income Y and the unemployed income Z and

the transition probabilities p and q remain constant through time. Given that we have

already assumed that the rate of return and the rate of discount are constant through

time, this means that things can be simplified considerably. In particular, the

information set Ùt, in addition to the constant parameters, Y, Z, p, q ,r and D and the

constant function U(.), contains only the employment status in period t. Thus the

7
optimal consumption strategies and the maximal value functions Vt(.|.) depend only

on the employment status. To make this explicit, let us write Vt(.|employed) = Rt(.)

and Vt(.|unemployed) = St(.) and use Ct and Dt to respectively denote (optimal)

consumption when employed and unemployed respectively in period t. Obviously

both these depend upon Wt.

Using this new notation we can write the general equation (4) in the following

two equations – the first corresponding to the employment state and the second to the

unemployed state:

Rt(Wt) = max[U(Ct) + D{pRt[(Wt –Ct)r + Y] + (1-p)St[(Wy - Ct)r + Z}] (5)

St(Wt) = max[U(Dt) + D{qRt[(Wt- Dt)r + Y] + (1-q)St[(Wt - Dt)r + Z}] (6)

As before, in principle, the individual’s problem is now solved: the optimal

consumption in period t when employed is simply the value of Ct which maximises the

term in square brackets on the right-hand-side of equation (5); the optimal

consumption in period t when unemployed is simply the value of Dt which maximises

the term in square brackets on the right-hand-side of equation (6). Substituting the

first of these (the optimal consumption when employed) back in equation (5) enables

the function Rt(.) to be derived from the functions Rt+1(.) and St+1(.); substituting the

second of these (the optimal consumption when unemployed) back in equation (6)

enables the function St(.) to be derived from the functions Rt+1(.) and St+1(.). The

recursion starts in the final period, period T, when, clearly RT(WT) = ST(WT) = U(WT)

for all WT . Hence, working backwards we can find recursively all the Rt(.) and ST(.)

functions and the optimal consumption levels in all periods and in both employment

states. Note that the latter are obviously functions of wealth, Wt , at the beginning of

period t.

8
 We note also that the equations which yield the optimal consumption

functions, that is, which maximise the terms in square brackets on the right hand sides

of equations (5) and (6) are usually termed the Euler equations. They can be written as

a condition involving the marginal utilities of present and future consumption if (1)

consumption can be chosen continuously and (2) if the solution is an interior solution

(that is, if borrowing constraints or non-negativity consumptions constraints do not

bind). As we shall see, neither of these conditions hold in our experiment so we do not

pursue the properties of these Euler equations here. More crucially we leave to the

particular parameters of our experiment a discussion of the properties of the optimal

consumption strategy: while general properties could be derived and discussed, it is

the particular properties that are being tested in this experiment.

Having said all that it is clear that there is a consumption function (as a

function of beginning-of-period wealth) for each time period (t = 1, 2, …, T) and for

each employment status. In general it is clear that the employed consumption function

will in general be everywhere above the unemployed consumption function (by an

amount that depends upon the parameters of the model), and that the functions will

generally rise as the horizon (period T) approaches. In the next section we will

describe these functions for the parameter sets used in our experiment.

3 The Experiment Implementation

3.1 Investigating the theory in the lab

It is clear that we cannot reproduce the Life-Cycle problem in the laboratory

exactly as it is in the theory – most importantly we cannot run an experiment which

lasts the lifetime of a subject. Moreover, certain terms that appear in the theory need

9
to appear in a different guise so that they are understandable to human subjects.

Accordingly the problem presented to subjects in the laboratory looks on the face of it

different from that which appears in the theory. However we shall show that

mathematically they have exactly the same structure. We begin by describing the

problem that subjects faced in our experiment. We then show that it has exactly the

same structure as (a special case of) the theory developed in sub-section 2.2 above.

We told subjects that they were taking part in an individual decision problem

which would last a certain number (we denote it here by T) rounds or periods, after

which the experiment would terminate. At the beginning of every period, the subject

would receive an income, denominated in tokens. This token income would, each

period, take one of two values, which the subjects were informed about at the

beginning of the experiment and which we denote here by Y and Z. The actual values

would be probabilistically determined by a process which we described in the

experimental instructions in verbal (layman) terms, but which can be more succinctly

described here as follows. The token income in the first period would be Y. In

subsequent periods, the value of the token income would be probabilistically

determined by its value in the preceding period: specifically, if the token income in

one period was Y, then the probability of it being Y next period would be p, and the

probability of it being Z would be (1-p); if the token income in one period was Z, then

the probability of it being Y next period would be q, and the probability of it being Z

would be (1-q). Tokens income could be accumulated to provide wealth – by a

process which we shall describe shortly. The subjects were told that, after being

informed about their income in tokens in each period, they had to then take a decision

– concerning how much of their accumulated token wealth they wished to convert

into money in that period. Let us denote this amount converted in period t by Ct.

10
Subjects were informed of the conversion scale (from tokens into money) that applied

to them; we shall describe later how this was communicated to the subjects, but it can

be more succinctly described here by a concave function, which we denote by U(.).

Thus C tokens converted into money yielded U(C) in money. Subjects were informed

that at the end of the experiment they would be paid in cash the total amount of

money converted from tokens over the T periods of the experiment. Furthermore,

while any unconverted tokens remaining at the end of the experiment would be

worthless, tokens accumulated during the experiment would incur interest at a

constant rate, which we denote here by (r-1) - so r denotes the rate of return on

accumulated tokens.

Given this payment scheme, it follows that the earnings of a subject over the

course of the experiment would be given by the value of the expression

U(C1) + U(C2) +…..+ U(CT) (7)

where C1, C2,…, CT denote the tokens converted in periods 1, 2, …, T.

Moreover, as viewed from the beginning of period t their payment over the remaining

periods of the experiment would be given by

U(Ct) + U(Ct+1)+…..+ U(CT) (8)

which implies that their expected earnings would be maximised if they adopted a

strategy which maximised the expected value of the expression given in (8). It will be

noted that this is exactly the same as that given by (1) above – where the discount

factor D takes the value 1. Thus the objective function of the subjects in our

experiment was exactly that of the model described above, in the particular case that D

takes the value 1, under the assumption that the subjects were risk neutral and hence

interested in maximising their expected payment for taking part in the experiment.

11
 Two extended notes are necessary at this stage. First, we should explain why

we take the special case of D equal to 1. This is for two reasons, the main one being

that it is difficult to induce real discounting in a laboratory experiment which lasts

around an hour of real time, unless one resorts to discounting induced by having a

probabilistic horizon, or unless one pays subjects interest on their accumulated money

earnings2. It is well known (see Dardanoni and Hey (1988)) that having a random

stopping probability equal to 1-D induces discounting equal to D in the sense that the

implied objective function is given by (1) above. However it is equally well-known

that subjects misperceive the implications of a constant stopping probability model

(similar to the well-known gamblers’ misperception that if red on a roulette wheel has

not come up for a long time then it is more likely to do so in the future). However,

given that r and D appear in the optimal solution to the problem described in the

theory section above always in the form rD it is clearly always possible to explore the

effect of a change in D by some appropriate change in r. We therefore decided to put

D equal to 1, despite the fact that this necessarily induces a non-stationary optimal

strategy. We shall have more to say about the complications this causes later.

The second extended note refers to the assumption of risk-neutrality

mentioned above. We justify this on two grounds: first that the subjects were paid on

all T periods of the experiment (thus averaging out any risk aversion); second, that the

amounts of money involved in each period were relatively small, which suggests that

the approximation of linearity of the subjects’ utility functions should be a reasonable

one. Of course, our results should be interpreted in the light of this approximation.

The rest of the model now falls into place. The rule about interest on

accumulated savings yields immediately the budget constraint Wt+1 = r(Wt - Ct) + Yt+1

2
We are indebted to Tibor Neugebauer for this suggestion.

12
(equation (4)) of the theory, where here Wt denotes the wealth of the subject at the

beginning of period t after income for that period has been received. The income

generating process described to the subjects is precisely the first-order Markov

process described in sub-section 2.2 above. We have reproduced in the laboratory the

theory of sub-section 2.2 above, in the special case where D =1.

3.2 The particular software details

The experiment was computerised (with a Turbo Pascal program) and subjects

performed the experiment individually at individual PCs. The participants in the

experiment initially saw a welcome screen, and then an instruction screen which

effectively repeated the instructions that they had already been given in written form.

In brief, they were told that the experiment would last 25 periods, in each of which

they would be given an income denominated in tokens. In each period the participant

had to decide how many tokens he or she wanted to convert into money that period.

The amount of tokens that was not converted in each period was credited to a token

account which earned interest. The participant was then informed that the payment for

taking part in the experiment was the sum of the amounts of money he or she obtained

by converting tokens into money in all 25 periods.

The participant was then told about the interest rate on accumulated tokens,

and then about the two possible levels of income that he or she could get, and finally

there was a description of the mechanism that would determine the income in the

following period. In the same screen participants were also told about the two key

probabilities3 determining this income generation process: the probability p of

remaining employed and the probability q of becoming employed.

3
Though we were careful not to use the word ‘probability’.

13
 At the beginning of each period there was a screen informing the participant

about their wealth from previous period, interest rate and current income. For the first

period the information was only about the current income.

In the following screen there was a graph (see Figure 1) showing the

conversion scale from tokens into money. On the right side of the conversion scale

there was a box which showed the value of any conversion that the participant wished

to discover. The following screen (see Figure 2) showed the random mechanism

generating the income for the following period. It will be recalled that the income

generation process is a first order Markov process, which was implemented using the

computer screens during the experiment in the following manner. The participant saw

a screen with eight blank cards displayed; he or she was then asked to choose one of

these cards; on the reverse side of the cards (initially invisible to the subjects) was

written the income she would get next period. This screen would determine which

state the participant would be in the following period; the probability of being

employed next period is given by the number of cards with the high income compared

to the total number of cards. This probability changes according to which is the

present state (employment or unemployment). All these probabilities were multiples

of 1/8.

3.3 The choice of parameters

It should be clear from the description of the model above that the relevant

parameters are the following: (1) the two possible income values Y and Z; (2) the

probability p of remaining employed; (3) the probability q of becoming employed;

and (4) the rate of return r. Additionally there are the parameters of the conversion

function; this took the following functional form:

14
U(c) = "[1 – exp(-R*c)].

This functional form is that of constant absolute risk aversion, with the parameter R

being the index of absolute risk aversion. The parameter " is the asymptote of the

conversion scale.

We report in Table 1 the parameter combinations used in the experiment. We

should explain the reasons for the choices of these particular combinations. First we

note that, in addition to testing whether the behaviour of the subjects is close to that

specified in the theory, one further thing that we wanted to do is to test the

comparative static predictions of the theory. These are obviously two different things

– the first tests whether behaviour is absolutely in agreement with the theory; the

second tests whether behaviour changes in the correct direction when the parameters

of the model change. It may be the case that the theory is absolutely wrong but has

correct comparative static predictions. To carry out a comparative static analysis we

need to vary the parameters. There are four (main) parameters of interest – namely

those listed in the paragraph above. The simplest set-up is to choose 2 values for each

of these parameters, and to take all possible pairwise combinations – giving us a total

of 16 parameter sets. Specifically, we took two values for Y namely 15 and 30.

Clearly it is the relative values of Y and Z that are important, so we did not vary Z but

kept it fixed throughout at the value 5. We chose two values for p (the probability of

remaining employed) and two values for q (the probability of becoming employed).

To maintain empirical validity, we require that the value of q is always less than the

value of p. In addition, we wanted the probabilities all to be multiples of 1/8 – to

make it easy for the participants to understand, and also so that we could use the card

mechanism (for playing out the Markov process) with 8 cards that we described

above. Accordingly we chose the two values of p to be 7/8 and 5/8 and the two

15
values of q to be 3/8 and 1/8. Finally we used two values for the rate of return, namely

1.2 and 1.4. We should note one further consideration that we took into account: that

the different parameter sets implied ‘significant’ differences in the implied optimal

consumption strategies. Clearly it is pointless testing for significant differences in

actual consumption behaviour if there is not such a difference in the associated

optimal strategies. We checked for such differences in the optimal strategies using a

program which calculates numerically the optimal strategy. We discuss this in more

detail later.

We discuss now the choice of the conversion scale; first, the parameter R

which is a measure of the concavity of the scale, and hence a measure of the

underlying risk aversion induced on the participants through this conversion scale.

Clearly R is something that we could have varied, but we were less interested in how

changes in the underlying risk aversion of the participants (as induced through the

concavity of the conversion scale) affected behaviour than in how the other

parameters affected behaviour. Accordingly we used the same value of R (specifically

0.015) throughout the experiments. However, given that different parameter sets

implied different expected earnings (following the optimal strategy) we varied the

asymptote of the conversion scale " across parameter sets, in such a way that the

expected earnings (following the optimal strategy) were the same for all parameter

sets. The above considerations led to the 16 parameter sets listed in Table 1 – formed

by taking all possible combinations of the various chosen values for the individual

parameters, namely: Y 30 and 15; p 7/8 and 5/8; q 3/8 and 1/8; r 1.2 and 1.4 (with

the asymptote " adjusted as described above.) Note that Z always took the value 5.

3.3 The implementation of the experiment in the EXEC laboratory in York

16
 Ninety six undergraduate and postgraduate subjects from the University of

York participated in the experiment. The experiment was run in twelve separate

sessions each involving eight subjects, all performing the experiment individually and

all proceeding at their own pace. On registration for the experiment, some days prior

to the experiment itself, all participants were sent a general set of instructions, giving

them general information about the task involved in the experiment, but without

giving any particular parameter values. On arrival at their experimental session,

participants were then given specific instructions for the parameter set that they would

be facing. Both the general and an example of a specific set of instructions are

appended to this paper. There was then a general briefing session and the

experimenter then showed them a simplified version of the experiment (using

computing projection from the experimenter’s computer). This simplified version

lasted just two periods, with parameters different from those used in the actual

experiment, and was intended to familiarise the subjects with the screens that they

would face, and how the software worked. No hints were given as to the ‘correct’ way

of tackling the experiment – nor indeed as to whether there was such a ‘correct’ way.

There was then an opportunity to ask clarificatory questions and then the subjects

commenced the experiment and completed it at their own pace.

3.4 How this experiment differs from previous experiments.

Other experimental work testing the life cycle model has been implemented by

Hey and Dardanoni (1988), Kim (1989), Kohler (1997) and Ballinger et al (2001). In

this sub-section we discuss how this paper differs from what has been done before,

concentrating particular attention on the papers by Hey and Dardanoni (1988), and by

17
Ballinger et al. A fuller discussion can be found in Ballinger et al (2001), which also

includes some discussion of the unpublished research of Kim and Kohler.

The model investigated by Hey and Dardanoni (1988) is essentially the basic

model described and discussed in section 2.1 – in one sense, therefore, a simplified

version of the model investigated here. However in the Hey and Dardanoni (1988)

model, while incomes are i.i.d. each period (rather than following a Markov process)

they are (truncated) normal variables (thus taking infinitely many possible values,

rather than just two as in this experiment). Moreover, the Hey and Dardanoni (1988)

experiment has a random horizon (induced by a constant stopping probability at the

end of every period) and hence has a stationary solution. In one sense this is good, as

the optimal strategy does not change through time (as it does in our model) thus

making the analysis of the results more straightforward. However, in another sense it

was bad, insofar as subjects (in the Hey and Dardanoni (1988) experiment) clearly did

not understand the stationarity properties of the model.

The model used by Ballinger et al (2001) is, again, a particular specification of

the model reported in section 2.1 but the specification they use differs from both from

that of Hey and Dardanoni (1988) and that of this paper. It differs from both in that

they use an i.i.d. multinomial distribution rather than a continuous random variable (in

a sense a case part way between Hey and Dardanoni (1988) and this paper). Like this

paper, and unlike that of Hey and Dardanoni (1988), they use a finite horizon – for

much the same reasons as we do here. Furthermore, Ballinger et al simplify the task

facing their subjects by having a zero rate of interest – effectively this means that they

concentrate attention solely on the precautionary motive for saving – rather than the

investment motive – which is clearly an important additional motivation in our

experiment and that of Hey and Dardanoni (1988). A final important difference with

18
the other experiments previously mentioned is that Ballinger et al consider

intergenerational learning.

4 Analyses of the results

We break down the analysis of the results into 4 sub-sections. In sub-section

4.1 we estimate using regression analysis the actual consumption strategies apparently

employed by the subjects, and then provide a comparison of these estimates with the

optimal strategies. As will become clear there seem to be strong differences between

the actual strategies employed and the optimal. In order to shed some light on the

possible causes of these differences, we present, in sub-section 4.2, a direct analysis

of the differences between the actual and the optimal. As will be seen, there are two

ways we can do this: first, by comparing the actual consumption with what would be

optimal given the wealth they actually had in that period; second, by comparing the

actual consumption with what would be optimal given the past income stream of the

subject and assuming optimal behaviour throughout. We discuss in more detail in sub-

section 4.2 what exactly we mean by this. Then, in sub-section 4.3, we concentrate

particular attention on the important variables and parameters, asking the question

whether subjects are responding, at least qualitatively, correctly to changes in the

relevant variables and parameters. This is effectively a test of the comparative static

properties of the subjects’ behaviour. We do this in two different ways. Finally, in

sub-section 4.4, we try to work out what strategies the subjects are using, given that in

general they are not using the optimal strategy. We work on the assumption that

subjects generally are not able to solve the problem optimally, but instead adopt a

simplified heuristic of acting on the basis of a shorter horizon than is actually the case.

That is, we assume that subjects have a subjective horizon, less than the true one, and

19
act on the basis that the actual horizon is this subjective horizon. Obviously this

induces dynamically inconsistent behaviour, but it allows subjects to simplify the

rather complex problem that they face. This idea was introduced by Kohler (1997)

and further elaborated on by Ballinger et al (2001). We explain this in more detail in

sub-section 4.4. Anticipating somewhat, our results show that some subjects have

very short horizons while others have longer horizons.

4.1 Comparison between estimated actual and optimal consumption strategy

Because there is not an analytic solution to the optimal strategy4, we calculated

the optimal strategy numerically – employing a program using the software Maple5.

The program works, for each parameter set, by backward induction, starting in the

final (Tth) period – in which the optimal strategy is obviously to consume all the

wealth available at the beginning of that final period. This enables us to calculate the

value of the functions RT(WT) and ST(WT) for all values of WT. Obviously these are

simply equal to U(WT). There is a practical problem of deciding the set of possible

values of WT – we took as the maximum value the wealth that would be accumulated

at the beginning of period T if the individual was employed in every period and

consumed nothing throughout. The program now work backwards – first into period

T-1 and calculates the optimal consumption in that period for each possible value of

wealth at the beginning of that period and for each of the two possible employment

states. We restrict both consumption and wealth to integer values – as was the case in

the experiment. This enables an exact numerical solution to be obtained. This also

gives us the values of RT-1(WT-1) and ST-1(WT-1) for all possible values of WT-1. We

continue to work back in this way, finding for each parameter set and for each

4
Mainly because of the integer restrictions on consumption and wealth but also because of the
constraints that consumption can neither be negative or greater than wealth.

20
employment status the optimal consumption strategy in every period t and the

associated values of Rt(Wt) and St(Wt) for all possible values of Wt. When we graph

these optimal consumption strategies for each period and for each parameter set it is

clear that the optimal consumption strategy for each employment state is effectively

linear6 (with the obvious restriction that consumption can not be negative nor greater

than wealth7). That is, we can approximate the optimal strategy by the following

expression:

C = a + b W if 0 < a + b W < W; C = 0 if a +b W < 0; C = W if a + b W > W.

The parameters a and b depend on (1) the time period and (2) the parameters. The

way that they depend on time t is not simple: when t is small, a and b are roughly

independent of t, but as t approaches 25, a approaches 0 more and more rapidly, and

b approaches 1 more and more rapidly. Because there was no obviously apparent

functional form (and certainly not one we could justify theoretically) relating a and b

to t we decided to treat different periods as different, and describe the optimal strategy

and estimate the actual strategies period by period. We then examined, period by

period, the relationship between a and b and the parameters p, q, r and y, for each

employment state. To do this we estimated by regression analysis the relationship

between a and b and the parameters p, q, r and y, and the dummy variable e, where

e=0 indicates unemployment and e=1 indicates employment. We discovered that the

parameter a (the intercept of the optimal consumption strategy) depends on p, q, r, y,

e, and the interactive terms e*p, e*q, and e*y, which we respectively denote by ep, eq,

and ey. No other combinations of p, q, r, y and e have a significant effect on the

5
We can make available on request the program.
6
It is obviously not exactly linear as the values of consumption are restricted to be integers – so it is
actually in the form of a set of steps – but it is linear if one draws a curve through the steps.
7
This second restriction is in fact never binding.

21
intercept a. As far as the slope coefficient b is concerned, we discovered that only r

has any effect on it. So a in each time period is a linear function of p, q, r, y, e, ep, eq,

and ey, while b in each time period is a linear function of r. If we substitute these back

into the linear consumption function C = a + b W above, we conclude that the

optimal consumption strategy in each period takes the following form:

C = (a0 + a1p + a2q + a3r + a4y + a5e + a6ep + a7eq + a8ey) + (b0 + b1r)W (9)

that is, it is linear in p, q, r, y, e, ep, eq, ey, W and rW (where rW denotes r*W).

Since the optimal consumption strategy takes this form in every period, we used this

functional form to try to explain the actual consumption behaviour of subjects. We

took note of the fact that consumption is bounded between zero and wealth and

therefore carried out Tobit regressions, period by period, of the actual consumption on

the variables p, q, r, y, e, ep, eq, ey, W and rW. Obviously here W denotes the actual

wealth of the subject in that time period. The results are reported in Table 2. We

should note that we have excluded from these regression 6 subjects whose behaviour

seriously distorts the analysis – in the sense that they are clearly outliers. What these 6

subjects did was to accumulate enormous quantities of wealth – way in excess of the

optimal level of accumulated wealth. The maximum wealth under the optimal

strategy never exceeds 1,400 – yet there were a few subjects who accumulated wealth

in excess of 3,000 (including one who managed to accumulate 12,000). Clearly the

inclusion of such subjects distorts the regression analysis considerably and it could be

argued that there are good reasons for excluding them from the analyses, in the sense

that they clearly did not understand the experiment. We therefore decided to exclude

from the regression analyses reported here those households who accumulated ‘too

much’ wealth. We experimented with what is meant by ‘too much’ and decided that

22
3,000 was a reasonable level. First, because it was more than double what should have

been accumulated; second, because reducing it to a lower figure made very little

difference to the regression results. Six subjects were excluded on this definition. The

regressions report the results based on a restricted sample excluding these 6 subjects.

In Table 2 there are three rows for each time period (from 2 to 258). The

second row reports the estimated coefficients of the above mentioned 11 variables in

the Tobit regressions of actual consumption. In the first row, in order to make the

comparison with the optimal clear, we repeat the Tobit regressions, now regressing

the optimal consumption against the optimal wealth and report in the first row for

each period the estimated coefficients of the above mentioned 11 variables for the

optimal consumption. These numbers are, of course, the values of the parameters of

the optimal consumption function as given in equation (9) above. The third rows in

Table 2 report the standard deviations of the estimated parameters for the actual

consumption regression. In Table 1, a letter ‘a’ or a letter ‘b’ against a standard error

in the actual consumption regressions indicates that the estimated coefficient is

significantly different from zero (at the 5% level of significance). From this table we

see that often the coefficients of W and rW are significantly different from zero while

all the other parameters are only occasionally significantly different from zero.

Also in Table 2 a letter ‘b’ against a standard error indicates that the estimated

coefficient is significantly different from zero (at 5%) and not significantly different

from the optimal coefficient. Looking at this table we see that the coefficient of the

variable W in the estimated actual regressions has this property just five times. This

means that the coefficient of W when explain the actual consumption is generally

8
We should note that all subjects started period 1 with the high value of income – so they all had the
same level of wealth in the first period. Clearly this makes impossible any estimate of the consumption
function – as a function of wealth – in that first period.

23
significantly different from the optimal, which indicates that the variable W explains

the difference between actual behaviour and optimal behaviour which, according to

the theory it should not do. The variable rW, is significantly different from zero and at

the same time not significantly different from the optimal just seven times, which

means that also rW also often explains the difference between actual and optimal.

A comparison of the estimated coefficients with the optimal ones could be

made using Table 2. For example it is clear from the column giving the coefficients

on the parameter p that the signs are usually correct, but the magnitudes vary

considerably – mainly a consequence of the fact that the regressions are carried out

period by period. However, there is a problem of ascertaining whether a particular

parameter, or the employment status, has the correct influence on consumption

behaviour, as all the parameters and the employment status enter the equation twice –

once by themselves and once in interaction with another variable. To get round these

problems, we present a more systematic investigation of the ‘comparative static’

effects in sub-section 4.3. But for the record, it may be useful to give the following

summary:

(1) the variable p by itself usually has the correct positive sign but it is

occasionally (4 times out of 239) negative; moreover the magnitude of the

estimated coefficient varies considerably;

(2) the variable q by itself has similarly properties, though here the incidence of

incorrect negative signs is greater (8 times out of 23), as is the variability of

the magnitude of the estimated parameters;

9
We restrict attention to periods 2 through 24 – as we have explained already estimation is impossible
in period 1; in contrast the estimates on period 25 are wildly distorted by those subjects who did not
consume all their wealth in that period.

24
 (3) the variable y by itself has the same incidence of incorrect negative signs (8

out of 23) as the variable q by itself – but the variability of the estimated

coefficients is much lower;

(4) the variable r by itself usually has the correct negative sign but there are 6

time periods in which it is positive;

(5) the variable e by itself has an incorrect positive sign 10 times out of 23 and the

variability of the estimated coefficient is extremely high;

(6) the interactive term ep (= e*p) has an incorrect negative sign 8 times out of 23,

and again the magnitude is highly variable;

(7) the interactive term eq (= e*q) has an incorrect positive sign 11 times out of

23, and again the magnitude is highly variable;

(8) the interactive term ey (= e*y) has an incorrect negative sign 7 times out of 23,

but the variability of the estimated coefficient is not particularly high

(9) the variable W by itself has an incorrect positive sign just twice and usually
the magnitude of the estimated coefficient is close to that of the optimal;

(10) the interactive variable rW ( = r*W) always the correct positive sign

and the coefficients are not too far (but see later) from the optimal.

This discussion highlights the fact that it is difficult from this type of analysis

to discover whether subjects are responding correctly to the various variables –

because they all appear both by themselves and in some interactive term. We provide

in sub-section 4.3 a more satisfactory test of the comparative static predictions. In the

meantime, we look at the errors made by the subjects in the experiment.

4.2 An analysis of the difference between actual and optimal consumption

behaviour

25
 It is clear from the above that there is a marked divergence between actual

behaviour and the optimal. To try to understand what is driving this difference, we

present in this sub-section an analysis of the determinants of the difference between

actual and optimal consumption. However, we need first to specify what we mean by

optimal consumption in the context of a situation where subjects make mistakes in

determining their consumption at some stage in their life-cycle.. There are two

possible ways that we could define optimal consumption in some period. The first

way is to define optimal consumption as the consumption that would be optimal in

that period given the wealth that the individual actually has in a particular period.

However, if the individual has not behaved optimally in the past then the wealth that

he or she has in that period is not the level of wealth that would be optimal given the

actual income stream that the individual received in the past. This leads us to the

second definition. This is the level of consumption that would be optimal in that

period if the wealth of the individual was that that would have been the result of

consuming optimally in the past – given the actual income stream received. We have

therefore two kinds of ‘error’ – the first being the difference between actual

consumption and the optimal consumption defined in the first way (what would be

optimal in that period given the wealth of that period) – and the second being the

difference between actual consumption and the optimal consumption defined in the

second way (what would be optimal in that period given optimal behaviour in the

past). Ballinger et al also consider these two different definitions. They comment that

the first type of error “…measures only current period deviations from the optimal

policy – given that the optimal policy chooses on the basis of subject cash-on-hand10 -

10
Wealth in our terminology.

26
and because of this, we prefer this measure of error.” (page 17). We agree with them

but, like them, use both definitions of error in the analysis that follows.

Let us denote the first kind of error by e1 and the second by e2. If subjects are

behaviour optimally then these errors will always be zero. If they are behaving almost

optimally (that is, they implement the optimal strategy with a ‘tremble’) then these

errors should be white noise. That is, no variable should have a significant effect on

them. If one does then this variable is explaining some part of the deviation from

optimality. To investigate the possibilities we regress each of these separately against

the variables used as independent variables in Table 2 and the period number (t).

Obviously we can pool all periods together to do this analysis. The results of the

regressions, when the dependent variable is e1, are in Table 3. We ran both OLS

regressions and Tobit regressions, but the results are almost the same so we report

only the results of the OLS regressions. First, we ran the regressions on the full

sample. It can be seen from Table 3 that the coefficients that are significant are those

of the constant, r, W, rW and t. (Obviously here W refers to the actual wealth.) The

fact that the coefficient on t is significant and positive means that the magnitude of the

error increases through time – effectively that the subjects were relatively under-

consuming (relative to the optimal strategy) early on in the experiment and relatively

over-consuming (relative to the optimal strategy) later on in the experiment. Care

should be taken in interpreting this result – as account should also be taken of the

effect of wealth on the error. If the first row of Table 3 is examined we see that the

coefficient on W is 1.10 and that on rW is –1.08. Both are highly significant. Now

recall that r is either 1.2 or 1.4, so in either case the coefficient of W in this first error

equation is always negative (-0.196 when r is 1.2 and –0.412 when r is 1.4). This

means that the error declines as wealth rises – or for low values of wealth the subjects

27
over-consume and for high values of wealth they under-consume. It is clear that

many subjects did not save enough (that is they over-consumed) in the early stages of

the experiment when their wealth was low, and then they under-consumed later in the

experiment as they approached the horizon (as a consequence of over-consuming

earlier). When we exclude from the sample those subjects who saved an excessive

amount (that is, more than 3,000) then the coefficient on p becomes significant, whilst

the coefficients of the constant, r, W, rW and t remain significant. As we have already

discussed, it is difficult to use this kind of analysis to help us understand what the

subjects were doing – but it does enable us to conclude that the subjects do not

correctly respond to their wealth, the rate of return and the time period (and possibly

the parameter p – the probability of remaining employed.

When we repeat the analysis of the error using the second definition of the

error, we see from Table 3 that the same coefficients are significant but so also is the

parameter y (both using the full sample and the restricted sample). The sign is

negative – indicating that subjects do not correctly take into account the effect of an

increase in the level of their employment income – they do not respond sufficiently to

a higher employed income11.

4.3 Comparative static analyses

In this section we report the results of various comparative static analyses. To

be specific, we look at how optimal consumption and actual consumption change

when the parameters r, p, q and y change, and we focus particular attention on the

effect of the employment status on consumption. We begin however with Table 4, in

which we report, period by period, the coefficient on wealth in both the optimal

11
We should, of course, note that the comparative static analyses of the parameters p, q, y and r are
across subjects –since each subject faced just one set of parameters. But the effect of the employment
status e on consumption is both across all subjects and within subjects.

28
consumption strategy and the estimated consumption strategy, for the two values of

the rate of interest used in the experiment. The first column is the period; the second

and third columns the coefficient on wealth in the optimal and actual consumption

functions for r = 1.2; and the fourth and fifth columns the coefficient on wealth in the

optimal and actual consumption functions for r = 1.4. For example, taking the second

column, we see that for the low rate of interest (20%) the optimal marginal propensity

to consume out of wealth starts at 0.17 in period 2 (the same figure is valid for period

1), and stays around this level until period 9. It then rises at an increasingly faster rate

– until it reaches 1.0 in the final period (when the individual optimally consumes all

his or her residual wealth). In contrast, in the third column are the estimated marginal

propensities to consume out of wealth at the interest rate of 20%. This table contains

some interesting information: if we start by comparing the second and fourth columns

we see that the optimal consumption strategy has the property that the marginal

propensity to consume out of wealth is greater in all periods for a higher rate of

interest – if the rate if interest rises people should optimally consume more in all

periods. If we now compare the third and fifth columns we see that this is generally

true of the actual behaviour – the marginal propensity to consume is generally higher

at the higher rate of interest. However, in comparing the second column with the

third, and in comparing the fourth column with the fifth, the actual marginal

propensities to consume are generally lower than the optimal – so behaviour is

absolutely wrong but the comparative static predictions are correct. Furthermore the

actual marginal propensities to consume show some bizarre effects – actually being

negative in the early periods. This is a consequence of the regressions being across all

subjects – some subjects with low wealth consumed all their wealth, while others

were deliberately building up their wealth stocks in the early periods – thus leading to

29
a negative marginal propensity to consume in the early periods. But having said this,

we note from Table 4 that the actual marginal propensities to consume rise through

time – as they should do. Once again a confirmation that behaviour is wrong in an

absolute sense – but correct in a ‘comparative static’ sense. The final row of Table 4

reports the average12 marginal propensities to consume out of wealth – once again we

see that the actual are below the optimal but move in the correct direction when the

interest rate rises. In the subsequent analysis we just report and discuss these averages

– since there is a high variability in the period-by-period results13.

In Table 5 we report on a number of things, specifically (1) the effect of the

employment status on consumption; (2) the effect of p on consumption; (3) the effect

of q on consumption; (4) the effect of y on consumption and (5) the effect of r on

consumption. We begin with the first of these – the effect of the employment status on

consumption. As the variable e enters the equation interactively with p, q and y we

need to consider the various possible combinations that these may take. In Table 5 (1)

there are the eight possible combinations. We see that the average effect on optimal

consumption of a move from unemployment to employment is always greater when y

takes its high value than when it takes its low value. This is also true for the actual

effects but the magnitude of the actual effect is everywhere much higher – for

example when y is low and both p and q are high, moving from unemployment to

employment consumption should increase on average by 1.81 – however, in fact, it

actually increases on average by 12.00. Subjects over-react to being employed – they

increase their consumption excessively. Or, in other words, the subjects are

12
The average is over periods 2 to 24. We exclude period 25 in all the subsequent analyses since
significant distortions are evident in the final period because not all subjects consumed their entire
wealth (partly because of a bug in the experimental software which stopped subjects consuming more
than 999 in any one period).
13
If we had estimated the regressions over all periods, taking into account the way that coefficients
should change through, then we could have reduced this variability, but it would have introduced

30
excessively sensitive to their employment status. This is extremely interesting. It

suggests that subjects do not smooth their consumption optimally. This seems to

reflect a stylised fact of real life: while employed, people consume too much; while

unemployed, they consume too little. Perhaps this is a consequence of mis-perception

of the probabilistic process generating the employment states?

In Table 5 (2) we look at the effect of p on the consumption level. Because p

enters the equations not only by itself but interactively with e, we need to consider the

two possible value of e. When e is zero (one) - that is, the subject is unemployed

(employed), moving from the low value of p to the high value should on average

increase consumption by 5.03 (14.57). In fact the actual average consumption

increases by 23.64 (39.89). So subjects are considerably over-reacting to an increase

in p – it seems that subjects are not able to take into account correctly the effect of p

on their situation – a high value of p induces excess optimism, a low value of p

induces excess pessimism. A different story is apparent however in the effect of q on

behaviour: as Table 5 (3) shows, an increase in q from its low value to its high value

should increase consumption on average by 14.73 (5.68) when the subject is

unemployed (employed) whereas it actually decreases it by 1.0814 (increases it by just

0.15). Here subjects are under-reacting to an increase in q - possible they are over-

pessimistic for high value of q and over-optimistic for low values of q. The

asymmetric effects of p and q are particularly interesting.

In contrast, if we look at Table 5 (4) we see that subjects respond almost

correctly to a change in the employed income y. An increase of y from its low value to

its high value should increase consumption on average by 0.25 (0.43) when

unemployed (employed) – the actual average increase is 0.24 (0.76). One might

further complications – caused by the necessary inclusion of many interact terms in the regression
equations. This would have made the subsequent analysis of the results particularly difficult.

31
conclude from this that subjects find y (a fixed number) easier to think about than p

and q (probabilities). However this conjecture seems to be refuted by Table 5 (5)

which shows that subjects over-react significantly to changes in the rate of interest.

Perhaps reflects the fact that people under-estimate the effects of compound interest?

An alternative way of thinking about these comparative static effects is

presented in Tables 6, 7, 8 and 9. Whereas in Table 5 we used the results of the

regression analyses, Table 6 to 9 present a more descriptive exercise, in which we

simply present the average (both actual and optimal) consumption over all periods for

each parameter individually: r in Table 6, y in Table 7, p in Table 8 and q in Table 9.

In each table we give averages for the low value of the parameter and for the high

value – and for each we give the average actual and the average optimal, calculated in

the two different ways that we have already discussed: (2) is the optimal consumption

given the wealth they actually had that period; (3) is the optimal consumption if they

had behaved optimally throughout.

The tables are structured as follows: the first column indicates the period, then

we have two sets of five columns – the first five for the low value of the relevant

variable and the second five for the high value of the variable. The five columns

contain: (1), the average (across subjects) of actual consumption; (2), the average

(across subjects) of the optimal consumption using the first definition of optimal

(optimal consumption based on the wealth they actually had in that period); (3), the

average (across subjects) of the optimal consumption using the second definition of

optimal (optimal based on the income stream that they had received to date); 1-2, the

difference between actual and optimal according to the first definition; 1-3, the

difference between actual and optimal according to the second definition. Table 6

14
A figure not significantly different from zero however.

32
reports the results for the interest rate. It is clear from this table that individuals over-

consume for the first 9 periods and under-consume thereafter. An increase in the

interest rate seems to increase the difference between the actual consumption and the

optimal consumption (calculated with both definitions) so to begin with they consume

more then they should and afterwards in order to compensate they have to consume

increasingly less. However, the comparative static prediction is verified – when the

rate of interest increases, individuals should and do consume more everywhere.

In Table 7 we repeat the analysis for the parameter y (the income when

employed). An increase in y should increase consumption everywhere – and it does.

However, the absolute magnitudes of consumption are incorrect. An increase of the

employed income induces a higher consumption in the first few periods and therefore

an increase in the difference between actual and optimal.

Table 8 reports on the effect on consumption of a change in the parameter p

(the probability of remaining employed). From the results it appears that the increase

in p does have a noticeable effect on consumption (in the direction indicated by the

theory) and increases the magnitude of the errors made by the subjects.

Table 9 reports on the effect on consumption of an increase in the parameter q

(the probability of becoming employed). The result here are very interesting. We see

that when q increases the actual consumption for the first 7 periods of the experiment

decreases and the difference between actual consumption and optimal consumption

(according to both definitions) decreases. After the seventh period the actual

consumption increases. We think that when people incur the state of unemployment,

and when they have not yet accumulated enough wealth to feel safe, they perceive

much more the state of unemployment than the probability to become employed

again, therefore they reduce their level of consumption. However, by about the

33
seventh period they have accumulated a bit of wealth, or they have a better perception

of what is the probability to become employed again, and therefore when q increases

the level of consumption increases.

4.4: The Planning Horizons of the Subjects

It is very clear from the results that we have already discussed that not all

subjects solve the dynamic optimisation problem optimally. To do so requires a

process of backward induction extending to the 25-period horizon of the problem. We

could say that a fully-optimising subject has in this experiment a 25 period horizon –

in the sense that he or she has the ability to plan ahead 25 periods in the first period,

24 periods ahead in the second and so on. This is a computationally complex problem

so it is not surprising that some subjects appear not to have 25 period horizons. It

could be argued that they adopt some procedure to simplify the problem. One such

procedure is that suggested by Kohler (1997) and further elaborated on by Ballinger et

al (2001), in which subjects do not look as far as the correct horizon but instead act as

if there was a shorter horizon, which they ‘roll forward’ as time passes. For example a

subject with a planning horizon of two periods will always act as if the next period is

to be the last (except of course in the 25th period which they know is the last); a

subject with a planning horizon of three periods will always act as if the next-but-one-

period is to be the last (except of course in the 24th and 25th period when they know

that they are the next-to-last and the last respectively). A completely myopic subject

has a one-period horizon in that he or she always acts as if the present period is to be

the last (and therefore consumes all their income every period). More generally a

subject with an h period horizon acts, in period t, as if period t+h-1 is to be last

(except, of course, when t+h-1 is greater than 25, in which case they correctly

34
perceive how far away is the horizon). Of course, subjects with a horizon h less than

25 act in a dynamically inconsistent manner for the first 25-h periods of the

experiment. For example, a subject with a 2 period horizon acts in period t (for t < 24)

as if period t+1 is to be the last (in the sense that they decide period t consumption on

the assumption that they are going to consume all their remaining wealth in period

t+1), but when they get to period t+1 they do not actually consume all their wealth

but instead consume the amount that would be optimal on the assumption that they are

going to consume all their remaining wealth in period t+2. And so on.

We follow the procedure suggested by Ballinger et al in trying to estimate the

apparent planning horizons of the subjects. We do this as follows. For any planning

horizon h we can work out the optimal consumption of the subjects using the optimal

strategy (that we have already calculated) for the fully-optimal subject. In this,

optimal consumption in period t is a function of t, of wealth at the beginning of t and

of the employment status in that period. The fully-optimising subject – one with a 25

period horizon – always uses the function relevant for t in period t. In contrast a

subject with planning horizon h uses the function relevant for period 26-h in period t

(instead of the one relevant for period t) whenever t is less than or equal to 26-h, and

then uses the correct one (that is the one relevant for period t) when t is greater than or

equal to 26-h. As before there are two definitions of the ‘optimal’ consumption in any

period: (1) the consumption that would be optimal given the wealth that the subject

actually has in that period; (2) the consumption that would be optimal in that period

given the income stream that the subject actually had and given that he or she had

optimised in the past. We repeat that the second definition is more strict in that errors

are compounded – there could be departures from this definition of optimality both

through current period non-optimising and through having the wrong wealth at the

35
start of the period through non-optimising in the past. Ballinger et al prefer the first

definition. It has certain advantages – particularly in that it lets us see more clearly

whether subjects’ behaviour is improving through time.

We have estimated the apparent planning horizon of the subjects using both

definitions of optimal consumption in a period. Moreover we have used two ways of

estimating the ‘best fitting’ apparent horizon. Both rely on calculating, for any

apparent horizon, the difference between actual consumption and optimal

consumption for every period of the experiment and then averaging these errors in

some way. Ballinger et al calculate the mean squared difference (the mean square

error of actual consumption from optimal consumption). We use both that and the

mean absolute difference. We calculate these for all apparent horizons and then find,

for each subject, the apparent horizon which minimises this average difference. The

results are in Tables 10 and 11, the former using the mean squared difference and the

latter the mean absolute difference. Both tables give information on the ‘best’

apparent horizon for each subject for each error definition. It will be seen that there

are only minor differences in the results depending on which error definition is used

or which measure of the average is used.

It is clear from these Tables that there are substantive differences between

subjects. There are some subjects with extremely short planning horizons. For

example, subject 6 on parameter set 9 appears completely myopic – having an

apparent planning horizon of just one period on whatever definition of error and on

whatever measure of average we use. Effectively this subject is simply consuming his

or her income every period. In contrast there are subjects with very long planning

horizons – many having apparent horizons of 20 periods15. If we look at these latter

15
We should note that the optimal strategy is effectively the same for at least the first 10 periods of the
experiment – so a subject loses very little by having a horizon of 15 instead of 25. Indeed for the

36
subjects we see that they are indeed the ones who saved up reasonable amounts of

wealth during the experiment – realising that they could benefit from the high rates of

interest. In contrast, those subjects with relatively small apparent horizons built up

relatively small stocks of wealth during the experiment – not realising the returns that

were possible from the high rates of interest.

It would be of interest to see if there is any connection between the apparent

horizons of the subjects and the parameters of the model, but, as can be seen from

Tables 10 and 11, such an analysis is somewhat confused by the high variability

between subjects with the same parameter set. For example, with parameter set 1, the

apparent horizon varies from 2 to 20. However, we can get rid of some of this

variability by averaging over subjects with the same value of some particular

parameter. For example, half the subjects had a high rate of interest (40%), half a low

rate of interest (20%). If we use the mean squared difference measure based on the

second error definition, then for the first half of the subjects (those with a high rate of

interest) the average apparent horizon is 5.65 periods, and for the second half of the

subjects (those with a low rate of interest) an average apparent horizon of 6.13

periods. There seems to be nothing of economic significance here, and certainly they

are not statistically significantly different. Similarly for the subjects with a high

probability of remaining employed, their average apparent horizon is 5.67 and the

average for those with a low probability of remaining employed 6.10. For the subjects

with a high probability of becoming employed their average apparent horizon is 6.58

and those with a low probability of becoming employed it is 5.19: though these are

not statistically significantly different, the difference has a modest economic

significance – suggesting that those who are more likely to leave unemployment think

subject with a reported apparent planning period of 20 in these Tables, the mean differences between
actual and optimal is the same for apparent planning horizons of 20 to 25.

37
more carefully about the future. Finally for those with high incomes, when employed,

the average apparent horizon is 6.77, while for those with a low income when

employed, the average apparent horizon is 5.00. This is interesting – the greater

payoff to being employed seems to induce subjects to think more carefully about their

future. But none of these differences are statistically significant. The significant

differences seem to be between subjects and not between parameter sets. Put simply –

some subjects are better than others in that they have longer planning horizons.

5 Conclusions

One of the important conclusions of this study is contained in the sentence

above: subjects differ in their ability to solve the task. In particular, subjects differ in

their ability to think ahead – some subjects seem to be able to think a long way ahead,

others only a little way. We could classify subjects according to their ‘apparent

planning horizon’ – as discussed in sub-section 4.4. Alternatively we could classify

subjects according to the way they tackled the problem: on this criterion there seem to

be four basic types: (1) those who understand the basic nature of the problem –

including the returns from saving and the diminishing returns from consuming – and

who approach, in varying degrees, the optimal strategy; (2) those who are pre-

occupied with the present and who seem to think little about the future; (3) those who

simply seem to like to have wealth, who build up excessive amounts of wealth during

the experiment; and (4) those who seem rather confused – building up stocks of

wealth over cycles of around 4 or 5 periods and then consuming almost all of these

built-up stocks of wealth.

If we exclude from the discussion those subjects who seemed to get pleasure

from building up enormous stocks of wealth, we could conclude that virtually all the

38
others were trying, with varying degrees of success, to solve the optimisation problem

– though most with a too-short planning horizon or with a variable planning horizon.

As a consequence of this apparent myopia, it follows that the behaviour of the

majority of the subjects was such that they consumed too much in the early stages of

the experiment (when their wealth was low) and as a consequence had too low levels

of wealth in the later stages of the experiment and thus consumed too little in these

later stages. This behaviour could result either from a too-short planning horizon or

from an underestimation of the effect of interest on savings. However, it is clear that

subjects take into account the role of the rate of interest – indeed increasing their

consumption excessively when the rate of interest rises.

We also observe significant over-reaction to the current employment status:

subjects tend to consume too much in periods of employment and too little in periods

of unemployment. This is perhaps a manifestation of a more general phenomenon:

subjects do not seem to be able to smooth their consumption stream sufficiently – with

current consumption too closely tracking current income. This was also observed by

Ballinger et al (2001) and is frequently observed in analyses based on questionnaire

data. In this context it implies that subjects are worse off in periods of unemployment

than they need to be, and better off in periods of employment than they should be. It

prompts the question: how should governments take into account such myopia when

planning the state unemployment insurance scheme?

It seems clear that subjects have difficulty in correctly taking into account the

probabilistic structure of the income process. Although a particular simple process (a

first-order Markov process) from the point of view of a statistician, it is difficult for a

non-statistician to assimilate. Perhaps this is the reason for the inability to smooth

sufficiently the consumption stream, and perhaps also the reason why the key

39
parameters p and q have effects different from those predicted by the theory. In

particular, subjects over-respond to an increase in p, while generally16 under-

responding to an increase in q. Perhaps they regard the high value of p (0.875) as

effectively a case of permanent employment (while the low value of p is clearly a

risky case), and the low value of q (0.125) as effectively a case of permanent

unemployment (while the high value of q is clearly a risky case)?

Whilst subjects seem to have difficulty with the stochastic nature of the

income process, they seem to have much less difficulty in understanding the actual

values of income – as evidenced by the fact that they respond almost exactly correctly

to an increase in the level of employed income.

So individuals have trouble optimising and have trouble understanding the

stochastic structure of the problem. As a consequence they smooth their consumption

stream insufficiently and over-respond to the current situation. In the light of this

under-optimisation, it is an interesting open question as to how governments should

respond.

16
Though there is an interesting twist to this: in the early stages of the experiment subjects actually
respond in the wrong direction to an increase in q. Possible reasons for this are discussed in sub-section
4.3.

40
6 References

Ballinger T.P., Palumbo M.G. and Wilcox N.T. (2001), “Precautionary Saving and
Social Learning Across Generations: An Experiment”, unpublished mimeo

Hey J.D. and Dardanoni V., (1988), “Optimal Consumption Under Uncertainty: An
Experimental Investigation”, Economic Journal, 98, supplement pp 105-116.

Kim H. (1989), An Experimental Study of Consumption: Test of the Permanent

Income and Life Cycle Hypotheses, Indiana University unpublished dissertation.

Kohler J., (1997), “Making Saving Easy: An Experimental Investigation of Savings

Decisions”, University of Cambridge, Department of Applied Economics Working
Paper.

41
7 Instructions

7.1 General Instructions (given to subjects on registration)

EXPERIMENT ON DYNAMIC CHOICE

INSTRUCTIONS
This is an experiment on dynamic choice. It will last for twenty five
periods, in each of which you will be given a certain income denominated
in tokens. Each period you must decide how many tokens you are going
to convert into money. The amount you do not convert in any period will
be credited to a token account which will earn interest. Your payment for
taking part in the experiment will be the sum of all the amounts of money
that you obtained by converting tokens into money in all twenty five
periods. It will be paid in cash at the end of the experiment. You will not
get paid in respect of any tokens left unconverted at the end of the
experiment.

TIMING
This experiment will last 25 periods. The time you spend working
through these twenty five periods is entirely up to you: you can proceed
at your own pace.

INCOME
The income in each period can be a high income or a low income. If you
get the high income in one period you have a higher probability of getting
it again next period, if you get the low income you have a lower chance
of getting the high income next period. In the first period you will have
the high income.

CONVERSION
In each period you must decide how many tokens you want to convert
into money. An example of a conversion scale from tokens into money is
pictured in the figure appended to these instructions. The precise
conversion scale relevant for you will be given to you when you arrive
for the experiment. This figure will also be displayed on the computer
screen during the experiment, and you will be able to interrogate the
computer about the precise value of any conversion.

TOKEN ACCOUNT

42
The tokens that you do not convert in any period will be credited to a
token account which will be maintained in your name. This account
earns interest. This token account can never be overdrawn - that is, you
can never convert more than the amount in your token account at any
stage. The computer will keep you informed at all stages how many
tokens you have in your token account. For simplicity, when calculating
the number of tokens in your account, the computer will round this
number to the nearest whole number.

INTEREST
Your token account earns interest at a certain rate. Thus, if you have a
certain number of tokens in your account at the end of any one period,
then at the beginning of the next period you will this amount plus
accumulated interest at the specified rate.

NEXT PERIOD
At the end of each period there is a random mechanism that will
determine your income next period. As you have already been told, your
income in any period will be either a high income or a low income.
Moreover the chances of the income being high or low depend on
whether it was high or low the previous period. As you will discover the
random mechanism works as follows: on your computer screen will be
displayed 8 cards face down. On the face side of each card, invisible to
you at this stage, is written one of the two incomes. Using the cursor keys
on your keyboard you will be able to select any one of the 8 cards; by
pressing ‘Return’ you can turn the card over - revealing whether the high
income or the low income is written on its face; this will be the value of
your token income next period. Pressing ‘Return’ again, the face side of
the remaining 7 cards will be revealed.

PAYMENT
Your payment for taking part in the experiment will be the sum of the
amounts of money that you obtained by converting tokens in all the
twenty five periods. This sum will be payed in cash to you immediately
after you have completed the experiment. You will be asked to sign a
receipt for this sum and a statement confirming that you have taken part
in this experiment voluntarily. In publishing the results of this
experiment, your identity will not be revealed. Thank you for
participating.

43
When you will come to the experiment you will receive more detailed
instructions, specific to your experimental treatment. Read them
carefully and if you do not understand anything, please ask one of the
experimenters. It is clearly in your interests to understand the
instructions completely.

________________________________________________________

7.2 An example of Specific Instructions (given to subjects on arrival for the

experiment) (Parameter set 1)

EXPERIMENT ON DYNAMIC CHOICE

INSTRUCTIONS
This is an experiment on dynamic choice. It will last for 25 periods, in
each of which you will be given a certain income denominated in tokens.
Each period you must decide how many tokens you are going to convert
into money. The amount you do not convert in any period will be credited
to a token account which will earn interest. Your payment for taking part
in the experiment, will be the sum of all the amounts of money that you
obtained by converting tokens into money in all 25 periods. It will be paid
to you in cash at the end of the experiment. You will not get paid in
respect of any tokens left unconverted at the end of the experiment.

TIMING
This experiment will last for 25 periods. The time you spend working
through these 25 periods is entirely up to you: you can proceed at your
own pace, though clearly the more time you spend thinking about the
experiment the more money you should earn.

INCOME
Your income in each period will be either 30 tokens or 5 tokens. In the
first period you will have an income of 30 tokens.

CONVERSION
In each period you must decide how many tokens you want to convert
into money. The conversion scale from tokens into money is pictured in
the figure appended to these instructions. (You will be able to see it on
the computer screen during the experiment.) If you look at the figure you
will see, for example, that 50 tokens convert into 41p, 100 tokens convert
into 61p, and 150 tokens convert into 70p. When you are doing the
experiment you will see that, on the same screen where the figure is

44
displayed, you will also be able to interrogate the computer about the
precise value of any conversion.

TOKEN ACCOUNT
The tokens that you do not convert into money in any period will be
credited to a token account which will be maintained in your name. This
account earns interest. This token account can never be overdrawn - that
is, you can never convert more than the amount in your token account at
any stage. The computer will keep you informed at all stages how much
money you have in your token account. For simplicity, when displaying
the number of tokens in your account, the computer will round this
number up to the nearest whole number.

INTEREST
Your token account earns interest at the rate of 40%. Thus, for example,
if you have 10 tokens in your account at the end of any one period, then
at the beginning of the next period you will have 14 tokens.

NEXT PERIOD
At the end of each period there is a random mechanism that will
determine the value of your income in the following period. As you have
already been told, your income in any period will be either 30 tokens or 5
tokens. Moreover, the chances of it being 30 or 5 depend on whether it
was 30 or 5 the previous period. More specifically: if your income in one
period was 30 tokens then there are 7 chances out of 8 that it will be 30
tokens next period and 1 chances out of 8 that it will be 5 tokens next
period; if your income in one period was 5 tokens then there are 3
chances out of 8 that it will be 30 tokens next period and 5 chances out of
8 that it will be 5 tokens next period. As you will discover, the random
mechanism works as follows: on your computer screen will be displayed
8 cards face down. On the face side of each card, invisible to you at this
stage, is written either 30 or 5. More precisely: if your income this period
was 30 tokens then on 7 of the cards will be written 30 and on 1 of the
cards will be written 5; if your income this period was 5 tokens then on 3
of the cards will be written 30 and on 5 of the cards will be written 5.
Using the cursor (arrow) keys on your keyboard you will be able to select
any one of the 8 cards; by pressing 'Return' you can turn the card over -
revealing whether 30 or 5 is written on its face; this will be the value of
your token income next period. Of course, you cannot change the card
selected at this stage, though by pressing 'Return' again, the face sides of
the remaining 7 cards will be revealed, enabling you to check that the
appropriate number of the cards had 30 written on them and the
appropriate number had 5 written on them.

45
 PAYMENT
Your payment for taking part in the experiment will be the sum of the
amounts of money that you obtained by converting tokens in all the 25
periods. This sum will be paid in cash to you immediately after you have
completed the experiment. You will be asked to sign a receipt for this
sum, and a statement confirming that you have taken part in this
experiment voluntarily. In publishing the results of this experiment, your
identity will not be revealed. Thank you for participating.

IF THERE IS ANYTHING YOU DO NOT UNDERSTAND,

PLEASE ASK ONE OF THE EXPERIMENTERS. IT IS
CLEARLY IN YOUR INTERESTS TO UNDERSTAND THE
INSTRUCTIONS COMPLETELY.

46
Table 1: Parameter sets

Set p q r y
1 0.875 0.375 1.4 30
2 0.875 0.375 1.2 30
3 0.875 0.125 1.4 30
4 0.875 0.125 1.2 30
5 0.625 0.375 1.4 30
6 0.625 0.375 1.2 30
7 0.625 0.125 1.4 30
8 0.625 0.125 1.2 30
9 0.875 0.375 1.4 15
10 0.875 0.375 1.2 15
11 0.875 0.125 1.4 15
12 0.875 0.125 1.2 15
13 0.625 0.375 1.4 15
14 0.625 0.375 1.2 15
15 0.625 0.125 1.4 15
16 0.625 0.125 1.2 15

Key: p: probability of remaining employed

q: probability of becoming employed
r: rate of return
y: income when employed

47
Table 2: optimal, estimated actual and s.e. of estimated actual.
period var const p q y r e e*p e*q e*y W r*W
2 opt -59.38 6.37 15.31 0.28 -2.04 -5.48 8.63 -7.66 0.16 -0.53 0.59
2 act 49.74 3.34 -18.29 0.55b -34.70 -23.12 13.63 3.57 1.47a -2.12b 1.18
2 se 34.56 23.05 17.16 0.28 26.32 17.91 25.50 19.53 0.31 0.89 0.68
3 opt -55.13 6.19 17.03 0.30 -5.65 -4.47 8.48 -8.91 0.14 -0.53 0.59
3 act 79.54 -8.81 -21.14 0.12 -42.22 -66.9a 52.09 36.90 1.51a -2.47a 1.66b
3 se 41.68 28.26 20.95 0.32 29.86 22.13 31.64 25.21 0.39 0.77 0.59
4 opt -51.84 7.06 16.09 0.27 -7.60 -5.68 8.58 -8.98 0.19 -0.53 0.58
4 act 114.88 -31.84 26.23 0.86 -79.23 -34.20 61.33 17.48 -0.07 -2.98a 2.16a
4 se 68.22 45.21 29.58 0.50 43.16 38.29 50.84 35.93 0.59 0.86 0.65
5 opt -46.51 5.82 15.29 0.28 -10.77 -6.15 8.91 -7.44 0.18 -0.52 0.58
5 act -15.48 24.01 14.06 0.54 -0.18 -14.87 16.24 -10.77 0.72 -1.2b 0.82b
5 se 51.09 34.78 27.78 0.44 32.01 29.57 39.51 33.74 0.52 0.50 0.39
6 opt -41.49 7.22 15.11 0.29 -15.32 -4.14 7.82 -8.06 0.15 -0.52 0.58
6 act 15.07 31.58 -22.39 0.00 -16.92 0.87 -31.93 25.38 1.52a -1.3a 0.94b
6 se 38.31 33.39 25.75 0.38 26.78 27.49 38.28 31.24 0.47 0.35 0.27
7 opt -37.33 6.88 16.62 0.30 -18.37 -3.65 7.84 -9.14 0.14 -0.52 0.57
7 act -50.90 29.28 29.13 0.17 27.87 -3.35 -9.47 -39.16 1.35a -0.22 0.14
7 se 42.71 29.61 21.75 0.38 27.89 29.38 38.10 30.36 0.50 0.28 0.21
8 opt -27.96 5.65 15.06 0.26 -23.38 -7.34 10.56 -8.32 0.19 -0.51 0.57
8 act -70.05 24.18 4.97 -0.04 50.96 45.96 -69.94 6.87 0.95 -0.09 0.06
8 se 51.03 34.07 30.35 0.51 32.02 34.96 41.75 37.78 0.64 0.25 0.19
9 opt -24.54 6.43 16.10 0.27 -26.19 -6.34 9.39 -9.32 0.19 -0.50 0.56
9 act 87.15 37.82 6.03 -1.43 -64.99 -21.62 71.80 -124.8 0.61 -1.5b 1.25b
9 se 133.49 95.58 75.23 1.23 82.02 101.75 122.51 99.25 1.66 0.51 0.38
10 opt -17.17 6.48 16.02 0.28 -31.28 -5.55 8.73 -9.50 0.18 -0.49 0.55
10 act -68.93 -19.16 30.47 -0.04 69.70 -17.78 6.18 -16.68 1.45 -0.25 0.23
10 se 59.47 47.94 41.06 0.69 43.25 49.73 59.39 53.18 0.87 0.23 0.17
11 opt -8.84 5.85 15.49 0.28 -36.52 -6.31 9.75 -8.52 0.18 -0.48 0.55
11 act 180.70a -16.44 -53.05 1.40 -147.2a -17.61 26.47 75.07 -0.67 -2.25a 1.90a
11 se 70.91 52.63 46.28 0.80 45.88 55.63 65.15 58.57 1.00 0.21 0.16
12 opt -0.54 5.44 15.29 0.28 -41.79 -5.65 9.63 -8.79 0.16 -0.46 0.54
12 act 234.6a 4.46 -72.89 1.90 -204.6a 12.67 -8.69 78.64 -0.90 -2.27a 1.92a
12 se 110.62 81.88 71.06 1.21 76.59 87.29 104.68 91.46 1.55 0.33 0.25
13 opt 7.11 5.91 15.58 0.27 -46.87 -5.61 9.41 -9.08 0.16 -0.45 0.53
13 act -29.40 12.90 36.65 0.20 18.43 11.13 -4.32 -38.71 0.43 -0.39b 0.37b
13 se 54.73 35.85 34.91 0.58 36.39 39.70 45.78 44.54 0.75 0.15 0.12
14 opt 14.99 5.87 15.52 0.27 -51.64 -5.51 9.05 -8.89 0.17 -0.43 0.52
14 act -14.34 33.83 5.03 -0.28 8.26 -4.55 -19.26 4.57 1.07 -0.59b 0.55b
14 se 45.63 34.52 31.11 0.53 31.34 38.42 42.98 39.17 0.66 0.11 0.09
15 opt 23.41 5.49 15.01 0.27 -56.40 -5.78 9.68 -8.26 0.16 -0.41 0.50
15 act 33.83 20.41 -3.88 0.06 -29.91 6.00 3.77 31.48 -0.19 -0.68b 0.63b
15 se 70.68 50.80 49.04 0.81 47.13 56.20 63.64 61.58 1.03 0.15 0.12
16 opt 30.44 5.25 15.59 0.26 -60.06 -6.36 10.36 -9.57 0.18 -0.38 0.49
16 act -81.94 -17.45 56.78 -0.56 79.91 -9.67 53.41 -90.60 0.34 -0.36b 0.40b
16 se 68.36 47.98 47.21 0.79 47.00 55.04 63.23 61.60 1.03 0.14 0.11
17 opt 37.15 5.18 15.10 0.26 -63.08 -5.82 9.67 -9.41 0.18 -0.35 0.47
17 act 27.00 24.32 57.75 -0.23 -40.40 16.20 5.51 -43.50 0.34 -0.78a 0.75a
17 se 67.87 48.27 47.46 0.77 43.94 52.20 61.54 60.81 0.98 0.12 0.09
18 opt 42.38 4.92 15.37 0.25 -64.79 -5.66 10.03 -10.37 0.17 -0.32 0.45
18 act 28.68 43.07 21.97 0.04 -51.77 45.52 7.58 -5.56 -0.99 -0.99a 0.93a
18 se 90.58 58.34 56.16 0.93 59.36 71.69 81.21 77.98 1.28 0.16 0.12
19 opt 46.73 3.87 15.19 0.24 -64.83 -6.41 10.87 -10.17 0.19 -0.28 0.42
19 act 26.35 44.80 6.68 0.80 -60.42 44.55 -29.59 -2.94 -0.29 -0.84a 0.83a
19 se 81.96 51.74 51.90 0.83 53.17 64.81 73.24 72.58 1.16 0.14 0.11
20 opt 47.86 3.65 14.44 0.23 -62.33 -6.43 10.74 -10.33 0.19 -0.22 0.39
20 act -32.73 97.03 12.82 0.49 -35.61 31.92 -21.06 -33.34 0.24 -0.53a 0.58b
20 se 79.69 49.74 49.61 0.82 52.50 63.43 70.50 69.90 1.13 0.14 0.11
21 opt 46.67 3.36 13.72 0.21 -57.63 -6.61 10.58 -10.35 0.22 -0.15 0.36
21 act 210.4b 62.11 -140a -0.06 -180b -110.77 88.74 276.6a 0.16 -1.24a 1.18a
21 se 98.38 65.25 65.43 1.06 65.58 77.09 88.57 88.22 1.45 0.17 0.13
22 opt 43.31 1.81 12.45 0.18 -49.97 -7.11 11.52 -10.72 0.22 -0.06 0.32
22 act 371.8a 53.72 18.01 -2.42 -290.2a -157.57 90.56 45.99 4.43 -1.74a 1.64a
22 se 156.89 118.5 107.8 1.79 101.79 124.2 147.65 137.55 2.28 0.29 0.23
23 opt 34.35 1.04 10.56 0.14 -37.89 -7.05 11.01 -9.58 0.23 0.07 0.27
23 act 144.78 15.29 39.13 -1.96 -71.62 -205.9 164.36 -41.55 4.55 -0.15 0.29
23 se 187.85 130.8 119.2 2.00 126.33 152.1 174.25 162.06 2.66 0.42 0.34
24 opt 20.85 0.00 6.79 0.09 -21.44 -5.32 8.02 -6.79 0.21 0.32 0.19
24 act 284.54 75.37 -58.65 5.30a -304.8a 231.27 -93.83 -126.48 -6.00 -3.18a 2.67a
24 se 216.96 149.01 135.91 2.33 140.26 183.15 207.89 189.61 3.18 0.46 0.36
25 opt 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1.00 0.00
25 act -2177.8 760.29 1562.8 17.61a 1055.22 6039.7 -4790.6 -5184.1 -18.63 4.73 -4.03
25 se 3659.33 3888.6 3471.1 3.24 2764.5 3455.3 4875.7 4377.7 43.74 3.50 2.92

Key: a: indicates that the estimated actual is significantly different from zero (at 5%)
b: indicates that the estimated actual is also not significantly different from the optimal (at
5%)

48
Table 3: regressions explaining the error in consumption

Sample dep const p q y r e e*p e*q e*y W r*W t

var
Full e1 -521 94.1 -32 1.70 351- 14.0 118 -1.08 1.10 -1.08 2.21
-6.3 1.5 0.6 1.8 7.0 4.06 0.2 1.6 .9 7.2 9.7 3.4
0.1
Restricted e1 51.8 49.7 13.7 .251 - -5.2 .135 -8.5 .604 -1.09 .762 .082
1.7 2.1 .7 .7 56.5 .2 0 .3 1.4 15 13 .3
2.9
Full e2 663 -9.13 4.42 - -445 - 27.5 16.3 -.89 .359 -.156 -12.6
18 .3 .2 1.35 20 8.86 .8 .5 1.7 5.4 3.2 -44
3.2 .3
Restricted e2 856 -58.8 - - -567 - 36.8 -12 -.438 -.349 .438 -13.2
29 2.7 .758 1.48 31 15.1 1.3 .5 1.0 5.0 8.1 59
.04 4.5 .6

Key: the first row gives the estimated coefficients

the second row the t-values.
italicised entries indicate estimated coefficients significantly different from zero

49
Table 4: Effect of wealth on consumption (both estimated and optimal)

rate of interest = 20% rate of interest = 40%

Period optimal actual Optimal Actual
2 0.17 -0.70 0.29 -0.47
3 0.17 -0.48 0.29 -0.15
4 0.17 -0.39 0.29 0.04
5 0.17 -0.21 0.29 -0.04
6 0.17 -0.17 0.29 0.02
7 0.17 -0.06 0.29 -0.03
8 0.17 -0.02 0.29 -0.00
9 0.17 0.04 0.29 0.29
10 0.18 0.03 0.29 0.07
11 0.18 0.03 0.29 0.42
12 0.18 0.04 0.29 0.42
13 0.18 0.05 0.29 0.12
14 0.19 0.06 0.29 0.17
15 0.19 0.08 0.29 0.21
16 0.20 0.11 0.30 0.19
17 0.21 0.13 0.30 0.28
18 0.22 0.13 0.31 0.31
19 0.23 0.16 0.32 0.32
20 0.25 0.17 0.33 0.28
21 0.28 0.17 0.35 0.41
22 0.32 0.22 0.39 0.55
23 0.40 0.20 0.45 0.26
24 0.55 0.02 0.58 0.55
25 1.00 -0.10 1.00 -0.90
averages 0.22 -0.02 0.32 0.18

50
Table 5: Average effect of other parameters and employment status on
consumption (both estimated and optimal)

(1) average effect of employment status on consumption

Probabilities Employed income low (15) Employed income high (30)

optimal actual optimal actual
p high and q high 1.81 12.00 4.52 19.85
p high and q low 4.07 11.69 6.78 19.54
p low and q high -0.57 7.94 2.13 15.79
p low and q low 1.69 7.63 4.40 15.48

(2) average effect of probability of remaining employed on consumption

Unemployed Employed
optimal actual Optimal actual
5.03 23.64 14.57 39.89

(3) average effect of probability of becoming employed on consumption

Unemployed Employed
optimal Actual Optimal actual
14.73 -1.08 5.68 0.15

(4) average effect of employment income on consumption

Unemployed Employed
optimal Actual Optimal actual
0.25 0.24 0.43 0.76

(5) average effect of rate of return on consumption

Wealth = 100 Wealth =200

optimal actual Optimal actual
59.71 139.82 156.62 340.51

Key: 1) table entries show average effect (over periods 2 to 24) of moving from unemployment to
employment
2) table entries show average effect (over periods 2 to 24) of changing the value of p from its
low value to its high value (0.625 and 0.875)
3) table entries show average effect (over periods 2 to 24) of changing the value of q from its
low value to its high value (0.125 to 0.375)
4) table entries show average effect (over periods 2 to 24) of changing the value of y from its
low value to its high value (15 and 30)
5) table entries show average effect (over periods 2 to 24) of changing the value of r from its
low value to its high value (1.2 and 1.4)

51
Table 6: Period-by-period effect of the rate of return on consumption

low high
period (1) (2) (3) 1-2 1-3 (1) (2) (3) 1-2 1-3
1 8 0 0 8 8 10 0 0 10 10
2 10 0 0 10 10 12 0 0 12 12
3 12 0 0 12 12 16 0 0 16 16
4 14 0 0 14 14 19 1 6 18 13
5 12 0 0 12 12 21 2 16 19 5
6 12 1 3 11 9 21 5 33 16 -12
7 14 2 6 12 8 22 10 55 12 -33
8 17 3 12 13 5 29 18 78 11 -49
9 21 6 20 16 1 56 28 100 28 -44
10 22 8 31 14 -9 47 32 123 15 -76
11 23 11 43 12 -20 68 41 145 26 -78
12 27 16 55 12 -28 64 46 168 17 -105
13 30 20 68 10 -37 59 55 191 4 -132
14 33 26 80 8 -47 82 71 214 10 -133
15 41 32 93 9 -52 88 84 237 4 -148
16 43 38 105 6 -61 100 99 260 1 -160
17 52 45 117 7 -65 124 117 283 7 -160
18 56 52 129 4 -73 130 131 306 -2 -176
19 63 60 141 3 -78 139 144 328 -5 -189
20 67 69 153 -1 -85 151 160 351 -9 -200
21 78 80 165 -2 -88 174 179 373 -5 -199
22 94 92 179 2 -85 180 196 396 -16 -216
23 95 103 191 -8 -97 166 199 418 -33 -252
24 65 116 203 -50 -137 198 221 440 -23 -243
25 118 138 217 -19 -99 193 218 463 -25 -269

(1) - average actual consumption

(2) - average optimal consumption given the wealth of the period
(3) - average optimal consumption given the past income stream
1-2 - difference between (1) and (2)
1-3 - difference between (1) and (3)

52
Table 7: Period-by-period effect of the employed income on consumption

Low high
period (1) (2) (3) 1-2 1-3 (1) (2) (3) 1-2 1-3
1 5 0 0 5 5 12 0 0 12 12
2 6 0 0 6 6 16 0 0 16 16
3 9 0 0 9 9 19 0 0 19 19
4 13 0 0 13 13 20 1 6 19 14
5 12 0 0 12 12 21 2 16 20 5
6 12 0 7 12 6 20 5 30 15 -9
7 13 2 17 11 -4 23 10 44 13 -21
8 20 5 28 14 -9 26 16 61 10 -35
9 39 10 42 29 -3 38 23 77 14 -40
10 24 9 58 15 -34 45 31 95 14 -51
11 24 14 75 10 -51 67 39 113 28 -47
12 25 21 92 4 -67 66 41 131 25 -65
13 36 30 110 5 -74 54 45 149 8 -95
14 53 40 127 13 -74 62 56 167 5 -106
15 62 47 144 15 -82 67 69 186 -2 -119
16 69 54 162 15 -93 75 83 203 -9 -128
17 73 60 179 13 -106 102 101 221 1 -119
18 84 66 196 18 -112 101 117 238 -16 -137
19 73 71 214 2 -141 130 133 255 -4 -125
20 88 82 231 6 -143 130 146 273 -16 -142
21 98 92 248 6 -150 154 167 290 -13 -136
22 106 99 266 7 -160 168 190 309 -22 -141
23 99 104 283 -5 -184 162 198 326 -36 -165
24 90 115 300 -26 -210 174 221 343 -48 -170
25 130 130 317 -0 -187 181 225 363 -44 -181

(1) - average actual consumption

(2) - average optimal consumption given the wealth of the period
(3) - average optimal consumption given the past income stream
1-2 - difference between (1) and (2)
1-3 - difference between (1) and (3)

53
Table 8: Period-by-period effect of the probability of remaining employed on
consumption

low high
period (1) (2) (3) 1-2 1-3 (1) (2) (3) 1-2 1-3
1 9 0 0 9 9 9 0 0 9 9
2 8 0 0 8 8 14 0 0 14 14
3 10 0 0 10 10 18 0 0 18 18
4 13 0 1 13 12 20 1 5 19 15
5 12 1 5 11 7 22 1 11 20 11
6 13 2 13 10 -0 20 3 24 17 -3
7 14 5 24 9 -9 22 6 38 16 -16
8 20 10 37 11 -16 25 11 53 14 -28
9 25 15 50 10 -25 52 18 70 33 -18
10 30 20 67 10 -37 39 20 87 19 -48
11 50 27 83 23 -33 40 26 105 15 -64
12 50 28 101 21 -51 41 33 123 8 -82
13 39 31 118 8 -79 50 45 140 5 -90
14 46 40 136 6 -91 69 57 158 12 -89
15 53 50 154 3 -101 76 66 176 10 -100
16 60 61 171 -1 -111 83 76 193 7 -110
17 72 75 189 -3 -118 104 87 211 17 -107
18 78 88 206 -10 -128 107 95 228 12 -121
19 93 99 223 -6 -130 109 105 246 4 -136
20 86 111 241 -26 -155 133 117 263 16 -130
21 110 135 258 -25 -148 142 124 280 18 -138
22 127 159 276 -33 -149 147 129 299 18 -152
23 120 171 292 -51 -173 141 131 317 10 -176
24 139 202 309 -62 -170 124 135 334 -11 -210
25 157 201 327 -44 -169 154 154 353 0 -199

(1) - average actual consumption

(2) - average optimal consumption given the wealth of the period
(3) - average optimal consumption given the past income stream
1-2 - difference between (1) and (2)
1-3 - difference between (1) and (3)

54
Table 9: Period-by-period effect of the probability of becoming employed on
consumption

low high
period (1) (2) (3) 1-2 1-3 (1) (2) (3) 1-2 1-3
1 9 0 0 9 9 8 0 0 8 8
2 13 0 0 13 13 10 0 0 10 10
3 15 0 0 15 15 13 0 0 13 13
4 13 0 3 13 10 20 1 3 19 17
5 16 1 7 15 8 18 1 9 17 9
6 17 2 17 15 -1 16 3 19 13 -3
7 18 4 29 14 -11 18 7 32 11 -14
8 20 8 43 12 -23 26 13 47 12 -21
9 41 13 57 27 -17 36 20 62 16 -26
10 26 15 75 11 -49 43 25 79 18 -36
11 47 23 92 24 -45 43 30 96 13 -53
12 50 25 110 24 -60 41 37 113 4 -72
13 39 28 127 11 -88 50 47 131 3 -81
14 47 38 145 10 -98 67 59 149 9 -82
15 54 48 163 6 -109 75 68 167 7 -92
16 61 58 181 3 -119 82 79 184 3 -102
17 72 70 199 2 -127 104 92 201 12 -97
18 82 83 216 -0 -134 103 101 218 2 -116
19 93 90 233 3 -139 109 114 236 -5 -127
20 94 100 250 -6 -155 124 128 254 -4 -129
21 117 115 267 2 -151 135 144 271 -8 -136
22 125 128 286 -3 -161 148 160 289 -12 -140
23 122 134 303 -12 -181 138 168 306 -30 -167
24 141 154 322 -14 -182 122 182 321 -60 -198
25 126 150 339 -24 -213 185 206 341 -20 -156

(1) - average actual consumption

(2) - average optimal consumption given the wealth of the period
(3) - average optimal consumption given the past income stream
1-2 - difference between (1) and (2)
1-3 - difference between (1) and (3)

55
Table 10: horizon determined by minimisation of mean squared difference
between actual and ‘optimal’ consumption
first error definition – table shows apparent horizons of subjects

subject 1 2 3 4 5 6
parameter
set
1 2 5 2 20 2 2
2 9 3 19 3 5 3
3 3 2 2 5 3 11
4 2 3 2 6 2 21
5 11 5 2 20 2 4
6 5 20 4 2 15 20
7 5 4 13 2 14 17
8 4 3 11 7 13 3
9 2 14 18 2 3 1
10 14 2 17 2 17 2
11 7 2 6 5 6 3
12 1 3 2 7 8 5
13 4 2 17 5 2 2
14 4 13 2 2 5 3
15 3 2 2 3 1 2
16 2 2 12 8 1 2

second error definition – table shows apparent horizons of subjects

subject 1 2 3 4 5 6
parameter
set
1 2 5 2 20 2 2
2 8 3 21 3 4 3
3 3 2 2 5 3 6
4 2 3 2 6 2 21
5 4 2 2 19 2 4
6 4 19 4 2 13 20
7 6 4 15 2 19 20
8 4 2 9 7 7 3
9 2 19 19 2 3 1
10 11 2 8 2 17 2
11 5 3 5 5 5 3
12 1 3 2 7 8 5
13 4 2 19 5 2 2
14 3 9 2 2 5 3
15 3 2 2 3 1 1
16 2 2 16 6 2 2

56
Table 11: horizon determined by minimisation of mean absolute difference
between actual and ‘optimal’ consumption
first error definition – table shows apparent horizons of subjects

subject 1 2 3 4 5 6
parameter
set
1 2 5 2 20 2 2
2 8 3 18 3 5 3
3 3 2 2 7 3 10
4 2 2 3 6 2 21
5 11 4 2 8 2 4
6 5 20 4 2 15 20
7 20 3 13 2 14 17
8 4 2 12 7 13 3
9 2 13 18 2 3 1
10 14 2 17 2 17 1
11 7 17 7 16 5 4
12 1 3 2 6 7 5
13 4 2 17 5 4 2
14 4 13 2 2 5 4
15 3 2 2 3 1 2
16 2 2 12 9 1 2

second error definition – table shows apparent horizons of subjects

subject 1 2 3 4 5 6
parameter
set
1 2 5 2 20 2 2
2 8 2 21 3 5 3
3 3 2 2 5 3 5
4 2 3 1 5 2 18
5 1 1 2 20 1 4
6 4 19 4 2 17 13
7 5 1 7 2 15 20
8 4 2 9 7 8 3
9 2 14 18 2 3 1
10 8 2 11 2 17 1
11 5 1 5 5 6 3
12 1 3 2 7 8 5
13 4 2 16 5 1 3
14 4 1 2 2 4 2
15 2 2 2 3 1 1
16 2 2 10 7 1 2

57
Figure 1: The basic decision screen showing the tokens/money
function

58
 Figure 2: The screen showing the random mechanism determining the next
period’s income/employment status

59

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