One does not have to watch “Keeping up with the Kardashians” to know that this U.S. family of celebrity millionaires pursues an exquisite lifestyle and maintains their status by spending an enormous amount of money. Only very few people in the world have the financial means to emulate that lifestyle. A research concept called “prospect theory” describes how comparing ourselves with others affects us, and how different attitudes towards risk with respect to gains and losses determine our economic activities.
For a long time, economic models assumed that homo economicus, a completely rational human being, maximizes his or her utility. The insolvency of the crypto exchange FTX, however, recently demonstrated once again that emotionally motivated behavior plays a major role in decision-making. These human aspects in our decision-making have been explicitly considered in scientific theory for quite some time, and the economist Jaroslava Hlouskova has derived formulas about the various ways in which our psychology influences consumption and investment decisions.
Hlouskova, a researcher at the Institute for Advanced Studies (IHS), has always been interested in human behavior and uses mathematical methods to model and examine economic decisions. Her derivations and solutions complement theories of mainstream expected utility theory, a branch that does not really consider emotional factors. “In our decision-making, the reference dependence plays a central role and must therefore be taken into account. We always evaluate a decision relative to a reference level, meaning that we compare our own consumption with, say, that of a friend or a colleague at work,” says Jaroslava Hlouskova. With the support of the Austrian Science Fund FWF, she has studied the behavior of private households under prospect theory.
This theory focuses on loss aversion and reference dependence as important factors influencing economic decisions. Loss aversion refers to the tendency to give more weight to possible losses (deterioration) relative to the reference level than to possible gains (improvement) relative to the reference level. Reference dependence describes the fact that the benefit of an alternative decision – for example spending a certain portion of income for consumption purposes or making more or less risky investments – is not measured in terms of the absolute level of wealth, but in terms of changes relative to a reference level (reference income). This reference level can be the Kardashians, the single parent next door, or one’s colleagues at work.
This is how you can be deceived: The two orange dots in the center are exactly the same size. Our perception depends on which reference size (gray dots) we compare them with.
Three benchmarks for calculations
Hlouskova, a specialist in quantitative economics, derived solutions for three different types of households: those with a very high reference level (ambitious households), those with a very low reference level (conservative households) and those with a neutral reference level. “We each have different preferences. How and which reference we choose, whether peers, higher earners or lower earners, is something my research cannot answer. I use reference levels as fixed parameters, i.e. as given, and these will yield results that can vary widely.”
In the two-period model used by Hlouskova, the reference in the second period may depend on the reference in the first period (or even on the consumption chosen in the first period): “I have derived the optimal consumption and investment decision in a two-period life-cycle model. In this context, the household must decide at the beginning of the first period how much consumption and investment it considers important. This decision will, in turn, influence the income and, accordingly, consumption in the second period.”
Hlouskova needed to handle many unknown parameters in her derivations. Her formulas describe well different decisions and the motive of fear. She collaborated with the economists Ines Fortin at IHS and Peter Tsigaris at Thompson Rivers University in Canada. Their research primarily yields theoretical results that are not immediately applicable, they might still be of interest to policymakers, however, when it comes to understanding optimal decision-making processes, for instance in the concrete design of taxes on income or capital gains. It has been clearly shown that “comparing upwards spoils enjoyment,” as Jaroslava Hlouskova puts it very succinctly. Happiness decreases with a rising reference level (such as reference consumption). The people who are most happy are those who do not compare themselves with others at all.
It is also easy to see that ambitious investors (those with a high reference level) increase their risky investments when times are bad, while conservative investors (those with a low reference level) do so when times are good. Moreover, ambitious investors accept even higher risks when the reference level increases, i.e. put more money into risky investments. Conservative investors, on the other hand, put less money into risky investments when the reference level rises.
Jaroslava Hlouskova is a senior researcher in the research group Macroeconomics and Business Cycles at the Institute for Advanced Studies (IHS) in Vienna. She studied numerical mathematics in Bratislava and completed the postgraduate program in quantitative finance at IHS. She was the faculty member at the University of Economics in Bratislava and Thompson Rivers University (Canada), was a scholar at the International Institute for Applied Systems Analysis (IIASA), and a consultant at the European Central Bank. Hlouskova is a committee member of the Slovak Research and Development Agency (APVV). Her research focuses on behavioral economics and forecasting economic and financial time series and commodity prices. The project “Modeling household behavior under prospect theory type preferences” (2016–2022) received EUR 293,000 in funding from the Austrian Science Fund FWF in the context of the Elise-Richter career development program.
Fortin I., Hlouskova J.: Prospect theory and asset allocation, IHS Working Paper series 42, June 2022
Hlouskova J., Tsigaris P.: Capital income taxation under full loss offset provisions of a prospect theory investor, in: Public Finance and Management, Special Issue on Behavioral Public Finance, Vol. 20/1, 2021
Hlouskova J., Fortin I., Tsigaris P.: The consumption-investment decision of a prospect theory household: A two-period model with an endogenous second period reference level, in: Journal of Mathematical Economics, Vol. 85, 2019