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Reference-Dependent Risk Attitudes

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  • Botond Koszegi
  • Matthew Rabin

Abstract

We use Koszegi and Rabin's (2006) model of reference-dependent utility, and an extension of it that applies to decisions with delayed consequences, to study preferences over monetary risk. Because our theory equates the reference point with recent probabilistic beliefs about outcomes, it predicts specific ways in which the environment influences attitudes toward modest-scale risk. It replicates "classical" prospect theory—including the prediction of distaste for insuring losses—when exposure to risk is a surprise, but implies first-order risk aversion when a risk, and the possibility of insuring it, are anticipated. A prior expectation to take on risk decreases aversion to both the anticipated and additional risk. For large-scale risk, the model allows for standard "consumption utility" to dominate reference-dependent "gain-loss utility," generating nearly identical risk aversion across situations. (JEL D81)

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File URL: http://www.aeaweb.org/articles.php?doi=10.1257/aer.97.4.1047
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Bibliographic Info

Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 97 (2007)
Issue (Month): 4 (September)
Pages: 1047-1073

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Handle: RePEc:aea:aecrev:v:97:y:2007:i:4:p:1047-1073

Note: DOI: 10.1257/aer.97.4.1047
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  1. SHALEV, Jonathan, . "Loss aversion equilibrium," CORE Discussion Papers RP -1456, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
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  7. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
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