Loss aversion in a consumption-savings model
Psychological evidence indicates that a person's well-being depends not only on his current consumption of goods, but on a reference level determined by his past consumption. According to Kahneman and Tversky's (1979) prospect theory, people care much more about losses relative to their reference points than about gains, are risk-averse over gains, and risk-loving over losses. We define these characteristics as loss aversion. We incorporate an extended form of loss aversion into a simple two-period savings model. Our main conclusion is that, when there is sufficient income uncertainty, a person resists lowering consumption in response to bad news about future income, and this resistance is greater than the resistance to increasing consumption in response to good news. We discuss some recent empirical research that confirms this predicted asymmetry in behavior, which seems inconsistent with other models of consumption.
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