Loss aversion and inefficient general equilibrium over the business cycle

Abstract

Empirical studies have shown that loss aversion is a relevant economic phenomenon at the aggregate level. This paper examines market efficiency over the business cycle with a representative loss-averse household. I analytically show that loss aversion causes inefficient competitive equilibrium. The household invests less in capital than an agent without loss aversion but should invest even less compared with the constrained optimum. Inefficiency exists because the household fails to internalize the effect of its investment on asset values. The numerical analysis indicates that the welfare loss of inefficient allocations is significant, nearly 3.5% of consumption. A policy to implement constrained optimal allocations requires capital taxation. Loss aversion is a source of aggregate market failures, implying that such behavioral elements may improve understanding of macroeconomic principles and total welfare. • I examine market efficiency regarding the business cycle under loss aversion. • Loss-averse households invest more than the optimal amount in capital. • The channel is that the household fails to internalize its effect on prices. • The government should tax capital at an economically significant rate. • The findings emphasize the role of behavioral elements in macroeconomics.