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A Model of Reference-Dependent Preferences

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Author Info
Botond Koszegi (University of California, Berkeley)
Matthew Rabin (Department of Economics, University of California, Berkeley)
Abstract

We develop a model that fleshes out, extends, and modifies existing models of reference dependent preferences and loss aversion while accommodating most of the evidence motivating these models. Our approach makes reference-dependent theory more broadly applicable by avoiding some of the ways that prevailing models if applied literally and without ancillary assumptions make variously weak and incorrect predictions. Our model combines the reference-dependent gain-loss utility with standard economic 'consumption utility' and clarifies the relationship between the two. Most importantly, we posit that a person's reference point is her recent expectations about outcomes (rather than the status quo), and assume that behavior accords to a personal equilibrium: The person maximizes utility given her rational expectations about outcomes, where these expectations depend on her own anticipated behavior. We apply our theory to consumer behavior, and emphasize that a consumer's willingness to pay for a good is endogenously determined by the market distribution of prices and how she expects to respond to these prices. Because a buyer's willingness to buy depends on whether she anticipates buying the good, for a range of market prices there are multiple personal equilibria. This multiplicity disappears when the consumer is sufficiently uncertain about the price she will face. Because paying more than she anticipated induces a sense of loss in the buyer, the lower the prices at which she expects to buy the lower will be her willingness to pay. In some situations, a known stochastic decrease in prices can even lower the quantity demanded.

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Paper provided by EconWPA in its series Method and Hist of Econ Thought with number 0407001.

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Length: 45 pages
Date of creation: 07 Jul 2004
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Handle: RePEc:wpa:wuwpmh:0407001

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B49 - Schools of Economic Thought and Methodology - - Economic Methodology - - - Other

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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Faruk Gul & Wolfgang Pesendorfer, 2005. "The Case for Mindless Economics," Levine's Working Paper Archive 784828000000000581, David K. Levine. [Downloadable!]
  2. Botond Koszegi & Matthew Rabin, 2005. "A Model of Reference-Dependent Preferences," Levine's Bibliography 784828000000000341, UCLA Department of Economics. [Downloadable!]
  3. René Garcia & Richard Luger, 2005. "The Canadian Macroeconomy and the Yield Curve: An Equilibrium-Based Approach," Working Papers 05-36, Bank of Canada. [Downloadable!]
    Other versions:
  4. Livio Stracca & Ali al-Nowaihi, 2005. "Keeping up with the Joneses, reference dependence, and equilibrium indeterminacy," Working Paper Series 444, European Central Bank. [Downloadable!]
  5. Botond Koszegi & Matthew Rabin, 2006. "Reference-Dependent Risk Attitudes," Levine's Bibliography 122247000000001267, UCLA Department of Economics. [Downloadable!]
  6. Ulrich Schmidt & Chris Starmer & Robert Sugden, 2005. "Explaining preference reversal with third-generation prospect theory," Discussion Papers 2005-19, The Centre for Decision Research and Experimental Economics, School of Economics, University of Nottingham. [Downloadable!]
  7. M. Keith Chen & Venkat Lakshminarayanan & Laurie Santos, 2005. "The Evolution of Our Preferences: Evidence from Capuchin-Monkey Trading Behavior," Cowles Foundation Discussion Papers 1524, Cowles Foundation, Yale University. [Downloadable!]
  8. Daniel Krähmer & Rebecca Stone, 2005. "Regret in Dynamic Decision Problems," Discussion Papers 71, SFB/TR 15 Governance and the Efficiency of Economic Systems, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich. [Downloadable!]
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