Reference Point Formation in Social Networks, Wealth Growth, and Inequality

Abstract

We investigate reference point formation in a social network of multiple investors and study its impact on wealth growth and inequality under a framework of Prospect Theory. The reference point of each individual investor contains both personal and social components. Whereas the personal component depends on the investor’s own history of wealth, the social component is determined by the wealth level of other investors in her network. In the benchmark case without social interactions and under the assumption of homogeneous preferences, each investor’s expected wealth grows at a common rate, the wealth gaps widens and the Gini coefficient remains constant. On the other hand, if the reference point is determined solely by social interactions, then, while the specific behavior depends on the model parameters, it is possible that the network simultaneously experiences high wealth growth and a reduction in inequality. Finally, for the general case where the reference point incorporates both personal and social components, we numerically show that increasing the degree of social interaction is beneficial for both increasing wealth growth and
reducing inequality.

Keywords: Cumulative Prospect Theory (CPT), Reference Point, Coefficient of Aspiration, Wealth Growth, Wealth Inequality, Gini Coefficient

JEL Classification: G11, G41