Pirttilä: Poverty and welfare measurement on the basis of Prospect Theory: an application to Russian data

Markus Jäntti (Stockholm University); Ravi Kanbur (Cornell University); Milla Nyyssölä (Aalto University School of Economics) and Jukka Pirttilä (University of Tampere and Labour Institute for Economic Research): Poverty and welfare measurement on the basis of prospect theory

Abstract: This paper examines the measurement of social welfare, poverty and inequality taking into account features that have been found to be important welfare determinants in behavioural economics. Most notably, we incorporate reference-dependence, loss aversion and the possibility of subjective probability assessments – aspects emphasised in Prospect Theory – to social welfare measurement. We suggest a new notion of equivalent income, the income level with which the individual would be equally well off, evaluated using a standard concave utility function, than he or she actually is, evaluated with a reference-dependent utility function. We examine the differences between standard poverty and inequality measures and measures that are calculated based on the notion of equivalent income for both realised income and expected wellbeing. These differences are illustrated using household-level panel data from Russia.
Key words: Prospect Theory, poverty, inequality, welfare measurement, vulnerability