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.

No additional funding sources recorded.