Which Decision Theory Describes Life Satisfaction Best? Evidence from Annual Panel Data

Abstract

We use an annual household panel to conduct a comparative analysis of which decision theory explains life satisfaction better. We consider expected utility theory and prospect theory. We consider the effects of three domains on life satisfaction: income, health, and (un)employment. Using a fixed effects estimator we find that life satisfaction contains features of both expected utility theory and prospect theory. However, the elements of expected utility theory are stronger predictors of life satisfaction. Life satisfaction depends positively on income, good health, and employment. It also depends positively on income and employment improvements, however the reverse is true for health improvements. Life satisfaction is concave in income gains and convex in income losses, and it exhibits loss aversion in income and employment status, but not in health. The results suggest that life satisfaction is best described by expected utility theory, but also contains some aspects of prospect theory.