Learning to reoptimize consumption at new income levels: A rationale for prospect theory

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Abstract

This paper provides a theoretical rationale for three experimental results of Prospect Theory: risk preferences are over gains and losses, loss aversion, and diminishing sensitivity. We consider a (boundedly rational) decision maker who does not find her new optimal consumption bundle with certainty when she is faced with a new income level. This alters her indirect utility function and makes her more risk averse at her current reference income level and less risk averse for a range of incomes below her reference income level.

Original languageEnglish (US)
Pages (from-to)98-114
Number of pages17
JournalJournal of the European Economic Association
Volume2
Issue number1
DOIs
StatePublished - Mar 1 2004

All Science Journal Classification (ASJC) codes

  • Economics, Econometrics and Finance(all)

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