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Gain-Loss Utility and Inefficiency in the Aggregate Stock Market

The paper studies the constrained efficiency of the aggregate stock market in which the investor obtains gain-loss utility directly from fluctuations in asset returns, in addition to consumption. I reveal that the competitive equilibrium is inefficient without any frictions as long as the agent has such preferences. Because of pecuniary externalities, the agent chooses more capital stock compared with what the social planner with identical preferences does. The numerical analysis shows that the welfare loss of the inefficiency is nontrivial. The policy used to implement constrained optimal allocations specifies that the government should tax capital to raise gain-loss utility.