Working Paper 2018-461
Income comparisons are important for individual well-being. We examine the shape of the relationship between relative income and life satisfaction, and test empirically if the features of the value function of prospect theory carry on to experienced utility. We draw on a unique dataset for a middle-income country, that allows us to work with an endogenous reference income, which differs for individuals with the same observable characteristics, depending on the perception error about their relative position in the distribution. We find the value function for experienced utility to be concave for both positive and, at odds with prospect theory, also negative relative income. Loss aversion is only satisfied for incomes that are sufficiently distant from the reference income. Our heterogeneity analysis shows that the slope of the value function differs across individuals who care differently about income comparisons, people with different personality traits, or social beliefs.
Authors: Martín Leites, Xavier Ramos.