Individual Rationality and Learning: Welfare Expectations in East Germany Post- Reunification

Transcription

1 DISCUSSION PAPER SERIES IZA DP No. 498 Individual Rationality and Larning: Wlfar Expctations in East Grmany Post- Runification Paul Frijtrs John P. Haiskn-DNw Michal A. Shilds May 22 Forschungsinstitut zur Zukunft dr Arbit Institut for th Study of Labor

2 Individual Rationality and Larning: Wlfar Expctations in East Grmany Post-Runification Paul Frijtrs Tinbrgn Institut, Fr Univrsity of Amstrdam John P. Haiskn-DNw DIW Brlin and IZA Bonn Michal A. Shilds Dpartmnt of Economics, Univrsity of Mlbourn and IZA Bonn Discussion Papr No. 498 May 22 IZA P.O. Box 724 D-5372 Bonn Grmany Tl.: Fax: This Discussion Papr is issud within th framwork of IZA s rsarch ara Evaluation of Labor Markt Policis and Projcts. Any opinions xprssd hr ar thos of th author(s) and not thos of th institut. Rsarch dissminatd by IZA may includ viws on policy, but th institut itslf taks no institutional policy positions. Th Institut for th Study of Labor (IZA) in Bonn is a local and virtual intrnational rsarch cntr and a plac of communication btwn scinc, politics and businss. IZA is an indpndnt, nonprofit limitd liability company (Gsllschaft mit bschränktr Haftung) supportd by th Dutsch Post AG. Th cntr is associatd with th Univrsity of Bonn and offrs a stimulating rsarch nvironmnt through its rsarch ntworks, rsarch support, and visitors and doctoral programs. IZA ngags in (i) original and intrnationally comptitiv rsarch in all filds of labor conomics, (ii) dvlopmnt of policy concpts, and (iii) dissmination of rsarch rsults and concpts to th intrstd public. Th currnt rsarch program dals with (1) mobility and flxibility of labor, (2) intrnationalization of labor markts, (3) th wlfar stat and labor markts, (4) labor markts in transition countris, (5) th futur of labor, (6) valuation of labor markt policis and projcts and (7) gnral labor conomics. IZA Discussion Paprs oftn rprsnt prliminary work and ar circulatd to ncourag discussion. Citation of such a papr should account for its provisional charactr. A rvisd vrsion may b availabl on th IZA wbsit ( or dirctly from th author.

3 IZA Discussion Papr No. 498 May 22 ABSTRACT Individual Rationality and Larning: Wlfar Expctations in East Grmany Post-Runification In this papr w tst th Rational Expctations hypothsis using longitudinal data on xpctations and ralizations of individual wlfar for East Grmans in th yars following runification. Grman runification was unxpctd and dlivrd a larg shock to th futur prospcts of th inhabitants of th formr East Grmany. W thrfor tak it as a 'natural' xprimnt through which to study th rationality of xpctations. Our rsults show that East Grmans significantly ovr-stimatd th wlfar gains immdiatly following runification. Th prdiction rror was largst for th young, th poorly ducatd and thos with childrn. Howvr, xpctations and ralizations of lif satisfaction in East Grmany had convrgd by 1995, at a lvl considrably blow that of Wst Grmans. W hnc conclud that xpctations wr clos to rational aftr th dust of runification had sttld, but that xpctations ar not likly to b rational in tims of grat transition or volatility. JEL Classification: C23, C25, I31, Z1 Kywords: wlfar, lif satisfaction, rational xpctations, larning, Grman runification Michal A. Shilds Dpartmnt of Economics Univrsity of Mlbourn Victoria 31 Australia Phon: Fax: mshilds@mlbcon.unimlb.du.au

4 I. Introduction Sinc its dvlopmnt in th 196s and 197s, th Rational Expctations (RE) hypothsis has bn a cntral componnt of dynamic conomic modls (Psaran, 1987; Dominitz and Manski, 1997). This has lad to two mpirical qustions: i) ar xpctations rational in th sns that individuals us all information availabl to thm to form unbiasd forcasts, and ii) do rportd xpctations contain usful information for conomists about futur conomic outcoms. Th scond of ths qustions has bn answrd positivly in th last 1 yars. Studis using aggrgatd xpctations data in tim-sris analysis hav found xpctations to contain information ovr and abov that availabl in th st of rgrssors (.g. Batchlor, 1986; L, 1994; L and Shilds, 2; Smith and McAlr, 1995). Robrts (1995, 1997) and Mankiw and Ris (21) hnc conclud that macro modls prform bttr in a varity of dimnsions whn survy-basd (inflation) xpctations ar usd in plac of constructd modl-consistnt rational xpctations. At th individual lvl, th usfulnss of xpctations data has also bn clarly confirmd: Flavin (1991), Dominitz (1993) and Alssi and Lusardi (1997), whilst not dirctly tsting th RE hypothsis, ach found a positiv corrlation btwn individual incom xpctations and futur ralizations. This rsult holds vn aftr controlling for all th othr information availabl to th rsarchr. Whthr xpctations ar rational is lss clar. Using aggrgatd data, th rsults appar mixd. Som studis confirm rationality; othrs rjct it (s Bonham and Cohn 21 for a rviw). This ambiguity has stimulatd discussion about which typ of data could rfut th rational xpctations hypothsis. Kan and Runkl (199) and Bonham and Cohn (21) hav argud that an unbiasd tst of RE can only b achivd by using individual or houshold lvl data du to th xistnc of 'microhtrognity'. This occurs whn individuals us diffrnt information sts whn making thir forcasts, lading to th rjction of th RE hypothsis in aggrgat data vn if xpctations wr rational on th individual lvl. Individual and houshold longitudinal data, whr a grat dal of information is known about rspondnts, allow th dirct idntification of th typs of individuals whos xpctations ar structurally incorrct. Most micro-studis so far hav rjctd rationality. Ths studis hav usd individual or houshold longitudinal data and hav focusd almost compltly on incom xpctations on yar ahad. Dominitz and Manski (1997) usd th Survy of Economics Expctations data collctd by th Univrsity of Wisconsin Survy Cntr in Thy found that forcast rrors in incom wr structural and could b attributd to ralizd incom, ag and mploymnt status. Das and van Sost (1999) and Das t al. (1999) invstigatd th sam issu using Dutch houshold panl data (ovr th sam on-yar horizon). Thir conclusion was that housholds do not form thir xpctations of futur 3

5 incom rationally, and that housholds whos incom dcrasd in th past undrstimatd thir futur incom growth. Soulls (21) analyzd micro-lvl data from th Michigan Survy of Consumr Attituds and Bhavior and found that xpctations appar to b biasd, and that individual forcast rror is corrlatd with dmographic charactristics. In this papr w invstigat whthr individuals mak rational forcasts and larn ovr tim using longitudinal survy data from th Grman Socio-Economic Panl (GSOEP). W us dirctly obsrvd xpctations ralizations of prcivd wlfar with a fiv-yar tim horizon. On advantag of our data is that virtually th whol sampl rport thir wlfar xpctations and thir wlfar outcoms. This is not th cas with incom (s.g. Das t al. 1999), whr sizabl fractions rport no answr to ithr th incom xpctation qustion or th actual incom qustion. Bcaus this non-rspons is a- slctiv, this svrly limits th robustnss of findings using incom xpctations. Anothr advantag is that our wlfar qustion is boundd on a (,1) scal. This mans that outlirs will not hav larg ffcts, contrary to incom qustions whr incom outlirs hav bn shown to hav larg consquncs for th rsults. 1 Th fiv-yar tim horizon in th qustions w us implis that xpctations rquir much mor thought from th rspondnts than th on-yar tim horizon usd in incom qustions. This also maks ths forcasts mor informativ about th xpctations procss: w xpct structural dtrminants of forcasting ability to com out much mor strongly with a longr tim horizon. W tst rationality in th aftrmath of Grman runification. Th runification of East and Wst Grmany is as clos to a 'natural' xprimnt as is xprincd in conomics: fw popl anticipatd th 'falling of th wall', nor th rsulting rapid ndowmnt of a formr communist country with a st of markt institutions. This mans it can b sn as a larg xognous shock, whos aftrmath should b vry informativ about th spd with which individuals adjust thir xpctations. Furthrmor it is th cas that th xpctations of th East Grmans had littl impact on th transition policis that th Wst- Grman govrnmnt dvisd for th East. This lack of policy ndognity maks Grman runification an almost idal cas for th study of th ractions of individuals to unxpctd larg changs in thir conomic and political nvironmnt. Th priod immdiatly following runification was a tim of grat optimism for both East and Wst Grmans, vn though thr was considrabl concrn about th conomic impact of runification on th Wst. For East Grmans this optimism was rflctd in popular slogans such as 'Hlmut (Kohl), tak us by th hand, lad us to th conomic wondrland' (Bach and Trabold, 2). 1 Incom outlirs hav larg ffcts on actual mans of incoms and thrfor on th qustion whthr xpctd and ralizd mans coincid (s Das t al for an informativ discussion. 4

6 Our masur of wlfar is th individual s subjctiv valuation of thir lif satisfaction, which is widly accptd by psychologists and a growing numbr of conomists as a good summary statistic for th wlfar of an individual (s Brtrand and Mullainthan, 21; Kahnman t al., 1999; and Oswald, 1997 for discussions). 2 It is thrfor rasonabl to suggst that ach individual will hold a maningful xpctation about his or hr futur lif satisfaction. To tst whthr individuals mak rational forcasts about thir futur lif satisfaction w construct both continuous and discrt modls of th forcast rror. Ths modls allow us to idntify th typ of individuals who mak th largst forcast rror and to s whthr or not individuals larn ovr tim. Th papr is prsntd as follows. Sction II introducs th data that w us, dfins th masurs of lif satisfaction and illustrats th lvls of currnt and xpctd lif satisfaction for East and Wst Grmans in th post-runification priod. Th mpirical mthods by which w xamin forcast rrors and larning ar discussd in Sction III. Th rsults ar prsntd in Sction IV. Conclusions ar drawn in Sction V. II. Data and Lif Satisfaction Profils following Runification A. Data To invstigat th rationality of East Grmans with rgard to thir xpctations of th wlfar (lif satisfaction) gains to thm from Grman runification, w us data from th Grman Socio-Economic Panl (GSOEP). Th GSOEP is a nationally rprsntativ panl that has closly followd around 13,5 individuals (living in som 7, housholds) ach yar sinc In 199, following runification, th panl was xtndd to includ rsidnts of formr East Grmany. 3 Th main focus of this papr is th mn and womn, agd 21-64, who rsidd in East Grmany, which w follow from 1991 up to Bcaus our analysis rquirs individual-spcific obsrvations of both xpctations (of t+5, at t) and ralizations (at t+5) of lif satisfaction w can only us individuals who ar obsrvd in th panl for at last a 5-yar priod. Consquntly, thr ar four possibl combinations of xpctations and ralizations that w obsrv btwn 1991 and 1999: ; ; ; and Out of th 4,1 East Grman's apparing in th GSOEP btwn 1991 and 2 Th us of lif satisfaction rsponss in cross-sctional and longitudinal survys, to gain a masur of individual 'utility' and tst compting conomic thoris, is in its infancy. Howvr, a numbr of rcnt studis hav illustratd th typs of qustions such data can addrss. For xampl, Di Tlla t al. (21) stimatd th rlativ importanc of inflation and unmploymnt in dtrmining rspondnt's lif satisfaction using cross-sctional survy data from th Euro-Baromtr Survy Sris ( ). 3 In this papr w us th Grman vrsion of th GSOEP data (s Haiskn-DNw and Frick, 2 for dtails), although th sam analysis can b conductd with th intrnational 'scintific us' vrsion, albit with around 5% fwr obsrvations. 4 Th qustion asking GSOEP rspondnts about thir xpctd lif satisfaction was only includd sinc 1991, thus w do not us th 199 data in this papr. 5

7 1999, w obsrv 2725 individuals ovr th rquird duration of 5-yars (not that th avrag duration of rspondnts in th panl btwn 1991 and 1999 was 6.4 yars). Th cass xcludd from our conomtric analysis ar a combination of thos who rmaind in th panl for lss than 5 yars (attrition) plus thos who ntrd th panl for th first tim post W hav chckd in dtail whthr thr was any slction on ithr initial satisfaction lvls or xpctd satisfaction lvls, but nithr turnd out to b th cas. Finally, as th data span almost a dcad, w hav dflatd all incom information by th OECD main conomic indicators consumr pric indx (bas yar 1995). B. Masuring Currnt and Expctd Lif Satisfaction Th dpndnt variabls w us in this analysis ar basd on two qustions askd to ach rspondnt in th GSOEP. Ths ar How happy ar you ar prsnt with your lif as a whol? immdiatly followd by, How happy do you think you will b fiv yars from now?' Both qustions ar basd on th sam ordinal scal: running from (vry unhappy) to 1 (vry happy). Whras th formr qustion has bn includd in th Wst Grman sampl of th GSOEP sinc 1984, th latr qustion was only addd in 1991 into both th East and Wst sampls of th GSOEP. Whilst th dtrminants of th rsponss to th first qustion hav bn widly xamind by conomists (s, for xampl, Clark t al., 21; Grlach and Stphan, 1996; and Winklmann and Winklmann, 1998), w ar unawar of any studis that hav lookd at th rlationship btwn xpctations and ralizations of lif satisfaction for ithr East or Wst Grmans. C. Currnt and Expctd Lif Satisfaction Profils Figurs 1 and 2 show th tim profils for currnt and xpctd lif satisfaction. For comparison, w hav also includd sparat profils for Wst Grmans (just ovr 11, individuals) ovr th sam priod. 5 A numbr of intrsting pattrns mrg. Firstly, currnt lvls of lif satisfaction in th East wr significantly lowr than in th Wst in vry yar. Scondly, whilst Wst Grmans xprincd a small gradual rduction in thir lif satisfaction following runification, East Grmans xprincd a largr improvmnt. Consquntly, th lif satisfaction diffrntial btwn East and Wst dclind following runification, but by 1999 a significant diffrntial still rmaind. Thirdly, xpctations of lif satisfaction at t+5 wr far highr than currnt lvls of lif satisfaction for East Grmans in th first fw yars following runification. East Grmans appar thrfor to hav bn optimistic about 5 Figurs 1 and 2: Th avragd data points for ach yar us th full sampl of East and Wst Grmans, rspctivly, obsrvd in th panl btwn 1991 and 1999 (i.. 25,93 prson-yar obsrvations for East Grmans and 63,868 prsonyar obsrvations for Wst Grmans. 6

8 th bnfits from runification. Fourthly, th divrgnc btwn actual and xpctd lif satisfaction was not vidnt for Wst Grmans, suggsting that Wst Grmans, on avrag, wr nutral with rspct to th anticipatd bnfits or costs of runification. Fifthly, actual and xpctd lif satisfaction had convrgd by 1996 for East Grmans. [FIGURE 1 ABOUT HERE] [FIGURE 2 ABOUT HERE] Tabl 1 illustrats th rlationship btwn xpctd and ralizations of lif satisfaction for East and Wst Grmans in mor dtail. In particular, it is clar that East Grmans ovr-stimatd th bnfits to thm from runification. For xampl, in 1991 th xpctation of lif satisfaction by East Grmans for 1996 was 7.31, whilst th man ralization in 1996 was This givs a man forcast rror of.93 (about 13%). In th following yars th siz of th forcast rror dclind sharply (almost linarly), and by 1994 East Grmans wr accuratly forcasting lif satisfaction. In contrast, th forcast rror mad by Wst Grmans was smallr at about 4% in 1991, and had disappard by [TABLE 1 ABOUT HERE] III. An Empirical Framwork for Tsting Individual Rationality and Larning Our approach to tsting th rationality hypothsis is to xamin th dtrminants of th rror btwn th lif satisfaction that individuals xpct for tim t+5 at tim t and th actual satisfaction thy rport at tim t+5. A. Th Continuous Cas Following Oswald (1997) and Di Tlla t al. (21), w assum that lif satisfaction rsponss can b tratd as a continuous variabl. W rlax this rstriction in th nxt sction. Assuming continuity maks th data informativ about whthr and how much xpctations diffr from outcoms bcaus thy ar dirctly cardinally comparabl. Compar this ability to cardinally compar outcoms and answrs with prvious rsarch using incom xpctations and businss cycl xpctations. Thar rasarch usd answrs to th qustion how likly individuals blivd that futur outcoms would b. Ths includ qustions of th form what do you think your incom will b on yar from now: lowr/th sam/highr ) (Kan and Runkl 199 or Bonham and Cohn 21). In such cass it is difficult to imply from x post knowldg of changs in obsrvd incom and actual businss cycls 7

9 whthr xpctations wr corrct or not. For instanc, it is not clar what th catgory th sam incom mans to individuals: Das t al. (1999) found that th sam incom corrspondd to small incom incrass. Thy suggst that this mans that individuals may hav th sam ral incom in mind or th sam rlativ incom. Hnc th incom concpt in xpctations and ralizations may diffr in an unknown way. Similar rsrvations hold for xpctations about inflation and businss cycls: what an individual prcivs as bing inflation and a businss cycl will for instanc dpnd on hr consumption packag and hr work situation. This prcption is furthrmor likly to chang ovr tim, which maks xpctations askd in on priod and outcoms in anothr priod difficult to compar. Such comparability problms ar not prsnt with our wlfar masurmnts. As in Tabl 1, w labl th xpctd lvl of lif satisfaction at t for t+5 as Et{ LS i, t + 5} and th actual lvl of satisfaction at tim t as LS it,. As a first approximation, w suppos th following rlation to hold: LS = f ( x, x ) + v + ε (1) it, + 5 it, it, + 5 i it+ 5 whr x it, ar obsrvabl individual charactristics including an intrcpt; v i is an individual fixd charactristic that can b rlatd to x; andε it a tim-varying rror-trm with unconditional xpctation that can b rlatd to x it, also. This gnral formulation mans w put virtually no structur on th rlation btwn x it, and LS it,. W now assum that Et{ LSi, t+ 5 } = LSi, t+ 5( x it, + 5) whr x it, + 5 is th anticipatd x it, + 5 by th individual at tim t. Thr thn holds E{ LS } LS = ( f( x, x ) f( x, x )) + ( ε ε ) (2) t i, t+ 5 i, t+ 5 i, t i, t+ 5 i, t i, t+ 5 i, t+ 5 i, t+ 5 which implis that th stimation rror has two parts. Th part with ( f( xit,, xit, + 5 ) f( xit,, xit, + 5)) is th part du to anticipation rror in obsrvd charactristics x it, and ( εit, + 5 εit, + 5) is du to anticipation rror in unobsrvd charactristics. W intrprt th Rational Expctations hypothsis such that thr should b no fundamntal prdictors of th rror in anticipation. Translatd to this modl, our H is that: Covx {,( f( x, x ) f( x, x ))} = Covx {,( ε ε )} = (3) it, it, it, + 5 it, it, + 5 it, it, + 5 it, + 5 8

10 Undr this assumption, w can fit an OLS of x it, on Et{ LSi, t+ 5 } LSi, t+ 5 whr undr H, th cofficints and th intrcpt should b qual to. B. Th Catgorical Cas W want to chck th robustnss of ths OLS rsults by rlaxing th assumption of continuity of th dpndnt variabls, bcaus th dpndnt variabls ar in actuality catgorical (ranging -1). W thn los th rathr convnint ability to simply look at th diffrnc btwn xpctations and outcoms as a cardinal masur of th forcast rror. W hav to mak mor spcific assumptions about th maning of xpctation answrs and outcoms in ordr to b abl to look at th rationality of forcasts. Many paprs using catgorical xpctations and outcoms hav takn xpctations to b probabilistic, i.. hav assumd that individuals hav a prcivd outcom probability distribution (.g. Mankiw 199 and Das t al. 1999). In that framwork, answrs to catgorical qustions hav to b translatd to probabilistic statmnts. On possibl assumption is to assum that th statd xpctd catgory is th modal catgory, i.. th catgory with th gratst xpctd probability mass of occurring. By looking at whthr th ralizations ar indd concntratd in th xpctd catgory, this lads to a simpl non-paramtric tst of rationality, though it dos not lnd itslf asily to infr th individual dtrminants of forcast rrors. Anothr assumption somtims mad is that th statd xpctd catgory includs th mdian of th xpctd outcom distribution. Rationality can thn b tstd by noting that whn th statd xpctd catgory contains th mdian, on should find lss than half of th ralizations ithr blow or abov th xpctd catgory. Again howvr, such a procdur dos not lnd itslf asily for th idntification of th structural dtrminants of forcast rrors. Th choic btwn possibl probabilistic intrprtations of th xpctations qustions is also somwhat ad hoc. In our cas, th probabilistic approach is not vry usful: th forcast rror is so larg in our data that th irrationality of xpctations shows up trivially undr any of th probabilistic assumptions abov. This mans w, mor ambitiously, try to look at th dtrminants of th forcast rror. W thrfor, as in th continuous cas, assum that individuals xpctation is a point-stimat and that th statd xpctd catgory contains that point stimat. This approach maks it possibl to look at th dtrminants of forcast-rrors. Thr is a corrspondnc with th probabilistic assumptions mad in much of th litratur though: undr th assumptions of our modl, our approach can b intrprtd as 9

11 corrsponding to th assumption that th rportd catgory contains th man and mdian of th xpctation. Spcifically, assum w hav: LS = x β + x β + ε * it, it, 5 it, 1 it L S = k LS [ λ, λ (4) * it, it, k k+ 1 * whr LS it, is latnt lif satisfaction; LS it, is obsrvd satisfaction; and λ k is th cut-off point (incrasing in k) for th satisfaction answrs. W do not intrprt th cofficints causally, which allows th possibility that β and β 1 includ th ffct of unobsrvabls rlatd to x, 5 and x,. W just assum th rsidual rror trm ε it to b indpndnt of xit, 5 and x it, and normally distributd. As normalizations for this ordrd-probit modl, w st λ =, λ 1 =, λ 11 = +, and Var{ ε it} = 1. W now assum that: it it E { LS } = LS ( x ) = x β + x β + ( x x ) β + ε + ( ε ε ) (5) * * t 5 i, t i, t i, t i, t 5 i, t 1 i, t i, t 1 it it it W translat th RE hypothsis to th H that x, 5 ( x, x, ),( ε ε it ), i.. that initial charactristics ar orthogonal to forcast rrors. it it it it W can now us ths assumptions as follows. First, w stimat β and β 1 from an ordrd probit * LS. By construction, x, 5 is indpndnt of LS x ˆ β x ˆ β. In turn, this also mans that on it, it, 5 it it, it, 5 it, 1 * x undr H is indpndnt of E { LS } x ˆ β x ˆ β. This mans that if w do an ordrd probit of it, 5 t 5 i, t i, t 5 i, t 1 * x on E { LS } x ˆ β x ˆ β, and st λ = ˆ λ, that undr H, w should find that th t 5 i, t i, t 5 i, t 1 cofficint ˆ γ PR of x it, 5 is zro. If w gt somthing diffrnt, this would b dirct vidnc of structural forcast rror. Thr mthodological points ar in ordr. Th first is that th xpctd stimat of β for th xpctation and th outcom is th sam vn if it only rprsnts a spurious rlation with unobsrvabls. This is bcaus th ffct of th rlation with unobsrvabls is th sam undr H for both xpctd satisfaction and actual satisfaction. Th scond point is that th normalizations ar diffrnt for th two analyss: th varianc of k k E { LS } will b highr than 1 * t 5 i, t bcaus it includs th trm ˆ ( x, x, ) β1+ ( ε ε it ). Hnc, assuming that this total rror trm is again it it it normally distributd, w hav to stimat this varianc. Thirdly, w not that w would not gt th 1

12 sam ˆβ 1 if w includd x it, as a rgrssor in th ordrd probit analysis of xpctd satisfaction, bcaus it will not b indpndnt of ( x, x, ), which is part of th rror trm. it it C. Spcification Tsting: OLS vs. Catgorical In ordr to b abl to judg th addd valu of th catgorical framwork, w hr dvlop a tst of th quality of th outcoms. W dnot th stimatd cofficints for xit, 5 of th OLS modl of forcast rrors by γ OLS. Our null-hypothsis is that th outcom of th catgorical modl is th sam, i..: OLS PR H: γ = αγ (6) whrα is an unknown positiv constant that ariss bcaus γ normalization than th ordrd probit cofficints γ. 6 Undr th null hypothsis, w can us th following liklihood ratio tst: PR OLS is stimatd undr a diffrnt PR OLS 2L( γ )-2L( αγ ) χ( k) (7) On practical problm is that α is unknown. To circumvnt this, w can not that: PR OLS PR OLS 2L( γ )-2L( αγ ) 2L( γ )-max {2L( ˆ αγ )} (8) ˆ α OLS PR OLS Hnc, by using th ˆ α that maximizs L( ˆ αγ ), w gt a lowr bound for 2L( γ )-2L( αγ ). If w PR OLS thus find that w can rjct th null using 2L( γ )-2L( ˆ αγ ) as our tst statistic, w know that th tru statistic will rjct th null also. D. Explanatory Variabls Th GSOEP contains a wid-rang of information about rspondnts' conomic, houshold and locational charactristics. In this papr on of our principal objctivs is to idntify th typs of individuals who mak th largst forcast rrors, and convrsly to idntify thos individuals whos forcasts ar th most accurat. W follow th rcnt conomics litratur (which partly builds upon a PR 6 γ is stimatd with var( ε it )=1. Th OLS modl stimats this varianc and dos not shar th sam normalization. 11

13 long history of lif satisfaction rsarch in psychology) that has invstigatd th conomic factors that impact on lif satisfaction in our choic of xplanatory variabls (.g. Clark t al., 21; Di Tlla t al., 21; Fry and Stutzr, 2; Winklmann and Winklmann, 1998). Consquntly, in th abov modls w control for th following individual and houshold charactristics: ag (and ag-squard), gndr, marital status, halth status (in trms of disability), numbr of childrn, yars of schooling, mploymnt status and houshold incom. A priori w might xpct that th forcast rror will b gratst for th young (with rlativly lss lif xprinc) and th unducatd (with th lowst larning ability). Howvr, ths ar conjcturs rathr than thory-basd priors. Givn our focus on Grman runification as a 'natural' xprimnt, w also control for whthr or not th individual livs on th bordr of th East and Wst, and whthr or not sh was a mmbr of th Communist Party prior to runification. In addition, du to th longitudinal natur of th data w also control for a numbr of rcnt 'lif vnts'. In particular, an individual's ability to corrctly forcast hr futur lif satisfaction may dpnd (a) whthr sh has xprincd a marital sparation or divorc in th last yar, (b) whthr sh has bn fird for a job in th last yar and (c) whthr sh movd from th East to th Wst following runification. 7 IV. Rsults A. Th Continuous Cas In Tabl 2 w show th OLS stimats for th four combinations of xpctations and outcoms availabl, i.. for E1991 { LSi,1996 } LSi,1996, through till E1994 { LSi,1999 } LSi,1999. For as of intrprting th intrcpt, w tak th dviations of x it, from its cross-sctional man. This allows us to intrprt th intrcpt as th avrag forcast rror. W s that th avrag forcast rror gos down from about 1 in 1991 to only.15 in Hnc w s a clar convrgnc of avrag xpctations to ralizations. This is th part w can put down to population forcast rror, i.. th dgr to which vryon had wrong xpctations. Howvr, thr ar clar individual diffrncs in forcast rror. Th old and mor highly ducatd individuals hav a smallr diffrnc btwn xpctations and ralizations, which in this cas mans lss absolut forcast rror also. What is also intrsting is that thos living on th bordr and thos having movd to th Wst from th East following runification had a much highr xpctd satisfaction than that which actually matrializd. This ffct dcrasd markdly ovr tim howvr: th dgr to which thos on 7 W obsrv 276 individuals who movd from East to Wst Grmany following runification. To allow for us to stimat th importanc of this mov in th ability of individuals to accuratly forcast thir lif satisfaction, w hav rtaind thm in th East Grmany sampl. 12

14 th bordr and thos having movd to th Wst wr wrong almost disappard by It is also clar that individuals with many childrn wr too optimistic in 1991 and byond. [TABLE 2 ABOUT HERE] Th cofficints of just bing fird, sparatd, or divorcd, ar insignificant and chang signs ovr tim. Hnc, thr is virtually no prdictiv powr in advrs lif vnts at th tim of th prdiction. Similarly, th cofficints of incom, disability lvl, whthr on was a mmbr of th communist party, whthr on was marrid, and gndr, ar not significant and also oftn chang signs. This mans that thy also hav littl prdictiv powr. Finally, th cofficints on mploymnt ar intrsting, for mploymnt starts off having no ffct, but nds up having a larg positiv significant ffct. By construction, this mans that th unmployd in 1991 had no diffrnt forcast rror from othrs in 1991, but had much lowr xpctations than outcoms in Th xpctations of th unmployd may wll hav bn ovrly pssimistic in 1994 du to th fact that 1994 was a rcssion yar and 1999 (which is th yar th xpctations wr for) was a boom yar in East Grmany. Hnc, this rsult may suggst that forcasts wr not only wrong aftr th grat transition in 199, but that thy ar also wrong ovr th businss cycl for slctd groups of individuals as wll. As for th prdictiv powr of individual charactristics, w can s by th dclining R 2 s that individual charactristics xplain littl of th varianc in th data in th latr yars of th panl. As a simpl dcomposition xrcis, w can writ: E{ E { LS } LS } = E( E { LS } LS ) + E( E { LS } E { LS }) (9) t i, t+ 5 i, t+ 5 t i, t+ 5 i, t+ 5 t i, t+ 5 t i, t+ 5 + ELS ( LS ) CovE ( { LS }, LS ) 2 it, + 5 it, + 5 t it, + 5 it, + 5 This dcomposs th squar forcast rror into th squar avrag forcast rror, th varianc in forcast, th varianc in ralizations and th covarianc. For th four priods, this dcomposition rads: EE LS LS 2 { 1991 { i,1996 } i,1996} = 5.25 = EE LS LS 2 { 1992 { i,1997 } i,1997} = 4.83 = E E LS LS 2 { 1993 { i,1998 } i,1998} = 4.64 = EE LS LS = = { 1994 { i,1999 } i,1999} Thr itms of intrst stand out hr: again w s th disapparanc of th population forcast rror 2 (= E( E { LS } LS ) ). W also s that th contribution of th population forcast rror to th total t i, t+ 5 i, t+ 5 13

15 squard rror in 1991 was about 2%. Comparing this with th approximatly 2% that all th individual charactristics combind contributd to th xplanation of 2 EE { { LS } LS }, w can conclud t i, t+ 5 i, t+ 5 that th importanc of individual charactristics compard to population charactristics in th forcast rror is almost ngligibl. This would indicat that xpctations ar indd, on avrag, roughly right apart from a bias shard by all individuals. Lastly, w s an incrasing Cov( Et{ LSi, t+ 5 }, LSi, t+ 5). This covarianc ssntially dnots th ability of individuals to prdict thir futur satisfaction, which apparntly incrasd ovr th yars following runification. W intrprt this as an indication that larning has takn plac in this priod. Summarizing, th rsults from our modls suggst th major part of th forcast rrors mad by East Grmans in th immdiat yars following runification was gnral to th ntir population. Howvr, thos with highr ducation, highr ag and thos not living on th bordr or having movd from th East to th Wst had th smallst forcast rror. Many of th individual prdictors of th forcast rror in 1991 had bcom insignificant by 1994, as had th avrag forcast rror. Our East Grman sampl also xprincd a fairly rapid incras (within four yars) in thir ability to corrctly prdict thir futur lif satisfaction. B. Th Catgorical Cas Th rsults of th stimation procdur for th poold ordrd probit spcification ar providd in Tabl 3. For dirct comparison, w also includ rsults for a poold ( ) OLS modl (th continuous cas). Importantly, th rsults ar vry similar to thos prsntd in Tabl 2, vn though w ar now pooling ovr th four sts of yars. From th ordrd probit modl w can s that xpctations in 1991 for lif satisfaction in 1996 ar on avrag wrong by about.75 points (=.44 + (1991- yar )*-.25), and only by.15 in [TABLE 3 ABOUT HERE] Th tst statistic for quality of th OLS and th probit cofficints is 8.6, which is an undrbound for th tru tst statistic. Th 1% critical valu of th corrsponding Chi-squar distribution for 17 dgrs of frdom is Th 1% critical valu of th Chi-squar distribution for 17 dgrs of frdom is Hnc, th null of qual cofficints cannot b rjctd for any rasonabl lvl of significanc. This fits prvious findings that a catgorical analysis of lif satisfaction lads to similar rsults as continuous analysis (.g. Di Tla t al. 21). It is also rmarkabl bcaus th probit rsults 14

16 rquird much strongr functional assumptions of rror-trms. Ths apparntly ar not important for th issu at hand. Again w s that th oldr and mor ducatd hav lowr prdiction rrors. Th mployd, thos on th bordr and thos having movd to th Wst hav highr prdiction rrors. Th stimatd standard dviation of 1.195, corrsponding to a varianc of 1.43, suggsts that compard to actual satisfaction rror, th forcast rror trm ˆ ( xit, xit, ) β1+ ( εit ε it ) adds anothr 43% varianc, which dos not sm implausibl. V. Conclusion In this papr w hav providd a novl tst of individual rationality and larning by using longitudinal data on currnt (t) and xpctd (t+5) wlfar for East Grman's in th yars following runification. Our data is drawn from th Grman Socio-Economic Panl (GSOEP), and shows that whilst currnt lvls of lif satisfaction in East Grmany immdiatly following runification wr considrably lowr than th lvls xprincd by thir Wst Grman countrparts, xpctations of lif satisfaction fiv-yars hnc wr high. Intrstingly, th avrag xpctd lif satisfaction for East Grmans in 1996, prdictd in 1991, was at a lvl roughly quivalnt to actual lif satisfaction in Wst Grmany in Clarly, xpctations of th bnfits from runification wr high in th East, with East Grmans having a 'rasonably' good ida of th lvl of lif satisfaction xprincd in th Wst. Both continuous and catgorical modls clarly rjct rationality in xpctations formation ovr th fiv-yar tim horizon that w hav xamind. W find strong vidnc of micro-htrognity in th sns of Bonham and Cohn (21): th unducatd, th young and thos with childrn had structurally highr forcast rrors. Howvr, ths individual charactristics xplaind only a small componnt of th total forcast rror, with th vast part of th forcast rrors mad by East Grmans in th immdiat yars following runification bing gnral to th ntir population. Morovr, many of th individual prdictors of th forcast rror in 1991 had bcom insignificant by 1994, as had th avrag forcast rror. It appars that virtually all East Grmans xprincd a fairly rapid incras (within four yars) in thir ability to corrctly prdict thir futur lif satisfaction. Th rsults thrfor indicat that larning about th aggrgat shocks took plac ovr this priod and that xpctations wr clos to rational in th priod Th broadr implications ar that th assumption of rationality dos not appar too bad in normal tims, but that it appars inappropriat in tims of grat transition. 15

17 FIGURE 1: Avrag Currnt (t ) and Expctd (t +5) Lif Satisfaction for East Grmans following Runification Avrag Currnt Lif Satisfaction Avrag Expctd Lif Satisfaction Lif Satisfaction Yar FIGURE 2: Avrag Currnt (t ) and Expctd (t +5) Lif Satisfaction for Wst Grmans following Runification Avrag Currnt Lif Satisfaction Avrag Expctd Lif Satisfaction Lif Satisfaction Yar 16

18 TABLE 1 Expctations, Ralizations and th Man Forcast Error for East and Wst Grmans EAST WEST Et{ LS i, t + 5} LS it, + 5 t i, t 5 E{ LS + }- it, 5 E{ LS + } it, 5 LS + t i, t 5 LS + t i, t 5 E{ LS + }- LS it, Nots: Et{ LS i, t + 5} is th xpctd lvl of lif satisfaction at t for t+5. LS it, + 5 is th ralizd lvl of lif satisfaction at t+5. E{ LS + }- LS it, + 5 is th man forcast rror. t i, t 5 17

19 TABLE 2 OLS Estimats of th Forcast Error: Expctd Lif Satisfaction (t+5) minus Actual Lif Satisfaction (t+5) Conditional on Individual Charactristic (t) Individual Charactristics γ t γ t γ t γ t Ag Fmal Marrid Sparatd or Divorcd Lvl of disability Numbr of childrn Yars of schooling Employd Non-participant Log houshold incom (post tax) Movd to Wst Grmany aftr runification Liv on th bordr of East and Wst Grmany Communist Party Mmbr bfor runification Sparatd or Divorcd in last 12 months Fird in last 12 months Intrcpt * R Obsrvations *Bcaus th intrcpts qual undr H, th R 2 is basd on th xplaind proportion of E{ E { LS } LS } t i, t+ 5 i, t

20 TABLE 3 Poold OLS and Ordrd Probit Estimats of th Forcast Error: Expctd Lif Satisfaction (t+5) minus Actual Lif Satisfaction (t+5) Conditional on Individual Charactristic (t) Individual Charactristics OLS ORDERED PROBIT Ag Fmal Marrid Sparatd or Divorcd Lvl of disability Numbr of childrn Yars of schooling Employd Non-participant Log houshold incom (post tax) Movd to Wst Grmany aftr runification Liv on th bordr of East and Wst Grmany Communist Party Mmbr bfor runification Sparatd or Divorcd in last 12 months Fird in last 12 months Yar Intrcpt R 2.1 NA Man log-liklihood NA χ Tst of paramtr quality (d.f. 17) NA ˆ α.742 Obsrvations γ OLS t γ PR t 19

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23 IZA Discussion Paprs No. Author(s) Titl Ara Dat 482 P. Kuhn C. Winbrgr Ladrship Skills and Wags 6 4/2 483 H. Rapoport A. Wiss 484 J. H. Bishop L. Wossmann 485 L. Wossmann M. R. Wst 486 A. L. Booth M. L. Bryan 487 R. L. Lumsdain E. S. Prasad 488 A. Ciccon G. Pri 489 D. Dl Boca S. Pasqua In-Group Coopration in a Hostil Environmnt: An Economic Prspctiv on Som Aspcts of Jwish Lif in (Pr-Modrn) Diaspora Institutional Effcts in a Simpl Modl of Educational Production Class-Siz Effcts in School Systms Around th World: Evidnc from Btwn-Grad Variation in TIMSS Who pays for Gnral Training? Nw Evidnc for British Mn and Womn Idntifying th Common Componnt of Intrnational Economic Fluctuations: A Nw Approach Idntifying Human Capital Extrnalitis: Thory with an Application to US Citis Employmnt Pattrns of Husbands and Wivs and Family Incom Distribution in Italy ( ) 1 4/2 5 4/2 5 4/2 6 4/2 2 4/2 1 4/2 5 4/2 49 W. F. Richtr Social Scurity and Taxation of Labour Subjct to Subsidiarity and Frdom of Movmnt 2 5/2 491 R. Rott C. M. Schmidt 492 R. Laliv J. Zwimüllr 493 R. M. Lontaridi M. E. Ward 494 J. Wagnr R. Strnbrg 495 J. T. Addison L. Bllmann C. Schnabl J. Wagnr 496 M. P. Kan E. S. Prasad On th Production of Victory: Empirical Dtrminants of Battlfild Succss in Modrn War Bnfit Entitlmnt and Unmploymnt Duration: Th Rol of Policy Endognity Work-Rlatd Strss, Quitting Intntions and Absntism Th Rol of th Rgional Miliu for th Dcision to Start a Nw Firm: Empirical Evidnc for Grmany Grman Works Councils Old and Nw: Incidnc, Covrag and Dtrminants Changs in th Structur of Earnings During th Polish Transition 5 5/2 6 5/2 5 5/2 1 5/2 3 5/2 4 5/2 497 D. Gatti Europan Intgration and Employmnt: A Nw Rol for Activ Fiscal Policis? 2 5/2 498 P. Frijtrs J. P. Haiskn-DNw M. A. Shilds Individual Rationality and Larning: Wlfar Expctations in East Grmany Post- Runification 6 5/2 An updatd list of IZA Discussion Paprs is availabl on th cntr s hompag