Modeling household behavior under prospect theory type preferences

The aim of my research project is to model a number of household`s decisions under prospect theory type preferences and to examine in addition a households behavior under different tax policies. The topic of this research belongs to the (interdisciplinary) field of behavioral economics where in addition to rationality (the core assumption of the main stream expected utility theory) also some psychological aspects are taken into account. These to some extent contribute to the explanation of some phenomena in financial markets which could not be justified by the traditional expected utility theory, such as the endowment effect (a gap between the willingness to pay to purchase something and the willing to accept a payment to sell the same thing), the equity premium puzzle (empirical phenomenon that stocks outperform bonds by a surprisingly large margin), the disposition effect (the tendency of investors to sell stocks whose price has increased too soon, while keeping assets that have dropped in value too long a feature observed in the late financial crises), and widely popular insurance portfolios. My research will be carried out in three parts. In the first part of my project I will examine prospect theory household`s decisions on consumption, savings and portfolio allocation. Savings are a central determinant of a long run economic growth of an economy and hence play an important part in determining economic prosperity and explaining inequality across households. The previous literature explored these decisions assuming people have expected utility preferences, and very little theoretical work has been devoted to examining such decisions under prospect theory preferences. Most work in behavioral economics has up to now been experimental in nature. In addition, I will examine the impact of various capital income taxation policies under such preferences on households consumption, savings, portfolio decisions, and welfare. The second part of my project will deal with labor market issues. There is empirical evidence that the economic crises in Europe have increased the incidence and intensity of second-job holding. My aim is to show that the prospect theory can provide valuable insights into such decisions. Thus, I will provide a behavioral economics explanation for workers to hold more than one job when leisure is included in their preferences. Finally, I will include the labor tax in the model and examine its impact on labor-leisure decisions under prospect theory. The third part of my project deals with the application and comparison of prospect theory and Dybvigs payoff distribution model in portfolio management. The payoff distribution model aims at targeting distributions of wealth (instead of utility functions) that incorporate some desired risk profile. These approaches will be applied to portfolio insurance and then together with traditional dynamic insurance strategies implemented, compared and evaluated.

The main goal of this research project was to model a household's decision under prospect theory preferences, where rationality is not the main factor determining behavior but reference dependence (comparison) and loss aversion, among others, are also important. The results show that reference dependence plays a significant role in determining decisions on consumption and portfolio allocations, in the effect of capital income taxes, as well as in labor market decisions, and should not be ignored. This mainly theoretical research was carried out in four parts: In the first part we examine the prospect theory household's decisions on consumption and portfolio allocation in a two-period life cycle model with both exogenous and endogenous second period reference consumptions. We examine three types of households depending on how the household's current consumption reference level relates to the average discounted endowment income: a less ambitious household, a household that compares to others belonging to the same social class and a more ambitious household. These households may act very differently and thus there is often a diversity of behavior. Among others we find that the household's happiness decreases with an increasing consumption reference level and thus not comparing at all will lead to the highest level of happiness. In the second part we examine a prospect theory household's behavior under different tax policies. We start with an investigation of the effects of endowment income taxation and then we focus on capital income taxation under full loss offset provisions with exogenous levels of reference consumption. This research shows that the reference level in relation to endowment income plays the most significant role in determining the effect of capital income tax changes. The third part of this project relates to labor market decisions, namely to multiple job holdings with leisure motivated by financial constraints, career development, psychological satisfaction as well as demographic and situational factors. We examine how a worker with prospect theory preferences allocates her time between leisure, a safe job, and a risky job such that her utility based on income and leisure is maximized. Comparative static analysis shows that making leisure time endogenous sometimes leads to several counter-intuitive results. Finally, the last part deals with the asset allocation of a prospect theory (PT) investor. In addition to the theoretical part, we empirically investigate the performance of a PT portfolio when diversifying among a stock market index, a government bond and gold, in Europe and the US, and compare it with the mean-variance (MV) portfolio, among others. We find that geography matters. In the US, PT portfolios outperform (in terms of returns and risk-adjusted performance) MV portfolios in most cases. In Europe, however, this is not the case.