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Learning to Reoptimize Consumption at New Income Levels: A Rationale for Prospect Theory

Author

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  • Markus K. Brunnermeier

    (Princeton University)

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 consump-tion 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. (JEL: D11) Copyright (c) 2004 by the European Economic Association.

Suggested Citation

  • Markus K. Brunnermeier, 2004. "Learning to Reoptimize Consumption at New Income Levels: A Rationale for Prospect Theory," Journal of the European Economic Association, MIT Press, vol. 2(1), pages 98-114, March.
    • Handle: RePEc:tpr:jeurec:v:2:y:2004:i:1:p:98-114
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    Citations

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    Cited by:

    1. David de Meza & David C. Webb, 2007. "Incentive Design under Loss Aversion," Journal of the European Economic Association, MIT Press, vol. 5(1), pages 66-92, March.
    2. Anton Suvorov & Jeroen van de Ven, 2008. "Goal Setting as a Self-Regulation Mechanism," Working Papers w0122, Center for Economic and Financial Research (CEFIR).
    3. Bernard, Carole & Liu, Fangda & Vanduffel, Steven, 2020. "Optimal insurance in the presence of multiple policyholders," Journal of Economic Behavior & Organization, Elsevier, vol. 180(C), pages 638-656.
    4. Choi, Kyoung Jin & Jeon, Junkee & Koo, Hyeng Keun, 2022. "Intertemporal preference with loss aversion: Consumption and risk-attitude," Journal of Economic Theory, Elsevier, vol. 200(C).
    5. Kyle, Albert S. & Ou-Yang, Hui & Xiong, Wei, 2006. "Prospect theory and liquidation decisions," Journal of Economic Theory, Elsevier, vol. 129(1), pages 273-288, July.

    More about this item

    JEL classification:

    • D11 - Microeconomics - - Household Behavior - - - Consumer Economics: Theory

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