Loss aversion and inefficient general equilibrium over the business cycle

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.