Previous studies have compared the behaviours of irrational individuals and so-called rational ‘social planners’, such as policymakers. Unsurprisingly, these two types of people have different financial behaviours. However, does the social planner make a different choice from the individual if they are equally irrational?
In recent research, Professor Meng Li at the City University of Macau used a real business cycle model and quantitative analysis to consider whether loss aversion affects the efficiency of the general equilibrium.
The term ‘general equilibrium’ refers to a stable economic system. This system is considered ‘efficient’ when it is impossible to make one person better off without making someone else worse off. Efficiency can be identified by comparing the market equilibrium and how social planners have distributed resources. If the social planner’s decision differs from the individual’s choice in the market, we usually consider that the market equilibrium is inefficient. In short, efficiency means that resources are distributed optimally.
Li finds that, if households behave according to loss aversion, the economy does not achieve the outcome desired by social planners. In a business cycle, individuals watch the ups and downs of asset values and define them against their reference point. They then attempt to avoid more harmful losses.
Households take returns on capital as given, not considering how their individual investment decisions influence overall returns. The household ends up accumulating more than would be required for an optimal economic state. The stock market ultimately becomes more inefficient the more weight that households give to loss aversion.
Li concludes that better outcomes could be achieved if households adjusted their investment behaviour. So, can a government intervene in order to reach a social optimum?
To explore this, Li added a government sector to his original model. He found that, in this environment, the conventional wisdom of zero capital tax rates is suboptimal. The government should tax capital if market participants are loss-averse.
Li’s study provides a model to show that loss-aversion leads to an inefficient economic equilibrium. It suggests that psychological states can lead to market failures.
This research broadens the horizon of economic theory by embracing concepts from behavioural economics. Policymakers may consider the effects of their decisions more carefully if they incorporate ideas such as loss aversion into their decisions.
