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Does Cognitive Ability Reduce Psychological Bias?

Publication Date:
Jan 2005
Project Programs:
Behavioral Economics

A burgeoning literature in economics argues that bounded cognition can explain many observed empirical deviations from rationality. Consistent with this hypothesis, we show that individuals with greater cognitive ability behave more closely in accordance with economic decision theory. However, even the most cognitively skilled individuals display significant biases. In two laboratory studies, one conducted with Harvard undergraduates and one with Chilean high school students, we find that individuals with greater cognitive ability are more patient over short-term trade-offs and less risk-averse over small-stakes gambles. In both studies, mathematical ability seems to be more predictive of normative decision-making than verbal ability. In the sample of Chilean students, achievement in elementary school (grades 1-6) is strongly predictive of decisions made at the end of secondary school. Drawing on the National Longitudinal Survey of Youth (NLSY), we show that, even after controlling carefully for labor income, more cognitively skilled individuals are more likely to participate in financial markets, are more knowledgeable about their pension plans, accumulate more assets, and are more likely to have tax-deferred savings. These findings persist when we use sibling relationships to identify models using within-family variation in cognitive ability. Finally, various institutional measures of school quality are predictive of sophisticated decision-making, suggesting a role for human capital policy in reducing the impact of psychological biases.

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