The consumption-investment decision of a prospect theory household: a two-period model with an endogenous second period reference level (Q2283139)

The two-period consumption-investment model suggested by the authors consists of the next basic equations. In the first period a household decides how to allocate a given exogeneous income, \(Y_1 >0\), to current consumption, \(C_1\), risk-free investment, \(m\), and risky investment, \(\alpha \geq 0\): \(Y_1 = C_1 + m + \alpha\). The sum of investments, \(S = m + \alpha\), is the savings defining consumption in the second period. The authors assume two states of nature: good (g) and bad (b) with the probability \(p\) of the good state \(g\). The net profit from the safe asset is \(r_f > 0\), and the net profit from the risky asset, \(r_s\), depends on the nature state \(s \in \{b, \ g\}\). Besides, in the second period, the household receives a non-stochastic income \(Y_2 \geq 0\). Accordingly, the value of the household consumption in the second period is depended on the nature state \(s\) in a way that \(C_{2s} = Y_2 + (1 + r_f)( Y_1 - C_1) + (r_s - r_f)\alpha\). At last, the household preferences are represented by the reference based utility function \(U(C_1, \ \alpha) = V(C_1-\bar C_1) + \delta V(C_2-\bar C_2) \), where \(V(\cdot)\) is a value function of the Kahneman and Tversky's prospect theory, \(\bar C_1\) and \(\bar C_2\) are some consumption reference levels, of which the former is exogeneous and the latter is endogenous, and \(\delta\) is the discount factor. The authors state and examine the optimal consumption problem for the household that is the maximizing the expected utility \(\mathrm{E}(U(C_1, \ \alpha))\) under some constrain relations on the variables \((C_1, \ \alpha)\) and parameters of the model. Three types of households are considered with respect to their ambition level relative to an average discounted income: less ambitious, neutral, and more ambitious. These types are determined by parameter relations.