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Forward-Looking Decision Making

Forward-Looking Decision Making: Dynamic Programming Models Applied to Health, Risk, Employment, and Financial Stability

Robert E. Hall
Copyright Date: 2010
Pages: 144
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  • Book Info
    Forward-Looking Decision Making
    Book Description:

    Individuals and families make key decisions that impact many aspects of financial stability and determine the future of the economy. These decisions involve balancing current sacrifice against future benefits. People have to decide how much to invest in health care, exercise, their diet, and insurance. They must decide how much debt to take on, and how much to save. And they make choices about jobs that determine employment and unemployment levels.Forward-Looking Decision Makingis about modeling this individual or family-based decision making using an optimizing dynamic programming model.

    Robert Hall first reviews ideas about dynamic programs and introduces new ideas about numerical solutions and the representation of solved models as Markov processes. He surveys recent research on the parameters of preferences--the intertemporal elasticity of substitution, the Frisch elasticity of labor supply, and the Frisch cross-elasticity. He then examines dynamic programming models applied to health spending, long-term care insurance, employment, entrepreneurial risk-taking, and consumer debt.

    Linking theory with data and applying them to real-world problems,Forward-Looking Decision Makinguses dynamic optimization programming models to shed light on individual behaviors and their economic implications.

    eISBN: 978-1-4008-3526-3
    Subjects: Economics, Mathematics, Finance

Table of Contents

  1. Front Matter
    (pp. i-iv)
  2. Table of Contents
    (pp. v-vi)
  3. Foreword
    (pp. vii-viii)
    Richard Blundell

    Forward-looking behavior is at the heart of economics. Choices over savings, occupations, earnings, investments, etc., all require forward planning under uncertainty. Just how individuals and firms go about doing this and how, as economists, we should best model what they do are key to our understanding of economic behavior and are the core concern of this book. Few people have had such an impact on the development of these aspects of economics as has Robert Hall.

    This volume makes a compelling case for the use of the dynamic-programming approach to modeling choices across a wide range of economic decision making....

  4. Preface
    (pp. ix-xvi)
  5. 1 Basic Analysis of Forward-Looking Decision Making
    (pp. 1-9)

    Individuals and families make the key decisions that determine the future of the economy. The decisions involve balancing current sacrifice against future benefits. People decide how much to invest in health care, exercise, and good diet, and so determine their longevity and future satisfaction. They make choices about jobs that determine employment and unemployment levels. Their investment decisions are at the heart of some issues of financial stability.

    Economists have gravitated to the dynamic program as the workhorse model of the way that people balance the present against the future. The dynamic program is one of the two tools economists...

  6. 2 Research on Properties of Preferences
    (pp. 10-22)

    The studies in this book use information about preferences from research on individual behavior. Consider the standard intertemporal consumption–hours problem without unemployment,

    ${\text{max}}\;{\mathbb{E}_t}\;\sum\limits_{\tau \, = \,0}^\infty {{\delta ^\tau }U\,({c_{t\, + \,\tau }},\;{h_{t\, + \,\tau }}),} $(2.1)

    subject to the budget constraint,

    $\sum\limits_{\tau \, = \,0}^\infty {{R_{t,\,\tau }}({w_{t\, + \,\tau }}\,{h_{t\, + \,\tau }} - {C_{t\, + \,\tau }}) = 0} $. (2.2)

    Here${R_{t,\,\tau }}$is the price at time 𝘁 of a unit of goods delivered at time$t\; + \;\tau $.

    I let$c\,(\lambda ,\,\lambda \,w)$be the Frisch consumption demand and$h\,(\lambda ,\,\lambda \,w)$be the Frisch supply of hours per worker. See Browning et al. (1985) for a complete discussion of Frisch systems in general. The functions satisfy

    ${U_c}(c\,(\lambda ,\,\lambda \,w),\;h\,(\lambda ,\,\lambda \,w))\; = \;\lambda $(2.3)


    ${U_h}(c\,(\lambda ,\,\lambda \,w),\;h\,(\lambda ,\,\lambda \,w))\; = - \,\lambda w$. (2.4)

    Here$\lambda $is the Lagrange multiplier for the budget constraint.


  7. 3 Health
    (pp. 23-41)

    In the American health system, families make some of the important decisions about health spending. They do so directly by some choices about when to seek care, and more indirectly as voices at their employers, who make choices about insurance coverage, and as citizens, because the government has a large role in financing health care for people over 64. In this chapter, based on a joint paper with my colleague Charles Jones (Hall and Jones 2007), a family dynamic program governs the choice between current consumption and investment in health. The model helps explain the growth of GDP spent on...

  8. 4 Insurance
    (pp. 42-49)

    The study of insurance fits naturally into a dynamic program. The family’s value function is almost always concave in wealth, so the family will want to trade a small payment made with certainty—the insurance premium—to avoid a large loss in wealth from an insurable event, such as a car accident, fire, or disability.

    This chapter looks at one important type of insurance, for long-term care, through the lens of a study by Brown and Finkelstein (2008) that exemplifies the modern approach to the analysis of policy questions. Long-term care in nursing homes and similar facilities accounts for 1.2%...

  9. 5 Employment
    (pp. 50-69)

    Dynamic choices of families are central to aggregate movements of key variables: hours of work, the employment rate, and consumption. This chapter asks how far the received principles of family choice can take the economist in understanding the cyclical properties of these variables. Figure 5.1 shows the data whose joint movements I seek to understand. The data are detrended to focus on the cyclical movements. The series are nondurables and services consumption per person, weekly hours per worker, the employment rate (fraction of the labor force working in a given week, 1 minus the unemployment rate), and the average product...

  10. 6 Idiosyncratic Risk
    (pp. 70-86)

    Like chapter 3, this chapter considers the burden on the individual or family from lack of insurance. In chapter 3, people did not buy insurance even though it was available—and even subsidized, in the case of women. In this chapter, insurance is nonexistent, even though the risk is enormous and the payoff to insurance would be gigantic if a market were possible.For good reasons, no insurance is possible.

    The chapter is about the risk that an entrepreneur in a high-tech startup faces. An entrepreneur’s primary incentive is ownership of a substantial share of the enterprise that commercializes the entrepreneur’s...

  11. 7 Financial Stability with Government-Guaranteed Debt
    (pp. 87-118)

    In modern economies, the government guarantees the debt of many borrowers. In a few cases, the promise is explicit; in others it is implicit but known to be likely; and in others, the guarantee occurs because the alternative is immediate collapse, with substantial harm to the rest of the economy. The modern government cannot stop itself from making good on the obligations of many borrowers, large and small. I demonstrate that debt guarantees deplete equity from firms at times of declines in asset values. Not only do firms fail to replace equity lost when leveraged portfolios lose value, but they...

  12. References
    (pp. 119-122)
  13. Index
    (pp. 123-126)
  14. Back Matter
    (pp. 127-128)