Poverty and Welfare Measurement on the Basis of Prospect Theory
39 Pages Posted: 12 Feb 2013
Date Written: January 31, 2013
This paper examines the measurement of social welfare, poverty and inequality taking into account reference-dependence, loss aversion and diminishing sensitivity — aspects emphasized in Prospect Theory — to social welfare measurement. We suggest a new notion of equivalent income, the income level with which the individual would be as well off, evaluated using a standard utility function, as he/she actually is, evaluated with a reference-dependent utility function. We examine the differences between standard poverty and inequality measures based on observed income and measures that are calculated based on equivalent income. These differences are illustrated using household-level panel data from Russia and Vietnam.
Keywords: Prospect Theory, poverty, inequality, welfare measurement, vulnerability
JEL Classification: I320, O120
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