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

Markus Brunnermeier

Journal of the European Economic Association, 2004, vol. 2, issue 1, 98-114

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.

Date: 2004
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