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A Model of Reference-Dependent Preferences

  • Botond Koszegi

    (University of California, Berkeley)

  • Matthew Rabin

    (Department of Economics, University of California, Berkeley)

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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File URL: http://econwpa.repec.org/eps/mhet/papers/0407/0407001.pdf
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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
Date of revision:
Handle: RePEc:wpa:wuwpmh:0407001
Note: 45 pages, Acrobat .pdf
Contact details of provider: Web page: http://econwpa.repec.org

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