Inefficient Reallocation, Loss Aversion and Prospect Theory
Working Papers from Department of Economics, City University London
The paper shows that bounded rationality, in the form of limited knowledge of utility, is an explanation for common stylized facts of prospect theory like loss aversion, status quo bias and non-linear probability weighting. Locally limited utility knowledge is considered within a classical demand model framework, suggesting that costs of inefficient search for optimal consumption will produce a value function that obeys the loss aversion axiom of Tversky and Kahneman (1991). Moreover, since this adjustment happens over time, new predictions are made that explain why the status quo bias is reinforced over time. This search can also describe the behavior of a consumer facing an uncertain future wealth level. The search cost justifies non-linear forms of probability weighting. The effects that have been observed in experiments will follow as a consequence.
Keywords: status quo bias; reference dependence; loss aversion; cost of choice; search costs; probability weighting; transaction costs; bounded rationality. (search for similar items in EconPapers)
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