Ranking Policies Under Loss Aversion and Inequality Aversion

Strong empirical evidence from laboratory experiments, and more recently from population surveys, shows that individuals, when evaluating their situations, pay attention to whether they experience gains or losses, with losses weighing more heavily than gains. The electorate's loss aversion, in turn, influences politicians' choices. We propose a new framework for welfare analysis of policy outcomes that, in addition to the traditional focus on post-policy incomes, also accounts for individuals' gains and losses resulting from policies. We develop several bivariate stochastic dominance criteria for ranking policy outcomes that are sensitive to features of the joint distribution of individuals' income changes and absolute incomes. The main social objective assumes that individuals are loss averse with respect to income gains and losses, inequality averse with respect to absolute incomes, and hold varying preferences regarding the association between incomes and income changes. We translate these and other preferences into functional inequalities that can be tested using sample data. The concepts and methods are illustrated using data from an income support experiment conducted in Connecticut.