On the theory of reference-dependent preferences

A theory is proposed in which preferences are conditional on reference points. It is related to Tversky and Kahneman’s reference-dependent preference theory, but is simpler and deviates less from conventional consumer theory. Preferences conditional on any given reference point satisfy conventional assumptions. Apart from a continuity condition, the only additional restriction is to rule out cycles of pairwise choice. The theory is consistent with observations of status quo bias and related effects. Reference points are treated as subject to change during the course of trade. The implications of endogeneity of reference points for behaviour in markets are investigated.     

Context effects: A representation of choices from categories

This paper studies a model of reference-dependent choice from sets of options grouped into categories. The proposed model is consistent with experimental evidence documenting context effects in a variety of choice situations. In our model, the reference point for any given category is subjective, and corresponds to the least preferred element in the category under consideration. Every object in a category is evaluated relative to the corresponding reference point; this may distort the objective ranking of options across different categories, and thus possibly give rise to a context-effects bias. The resulting representation is essentially unique. We also provide an economic application of the preferences that we axiomatize to principal-agent models. We show how sellers facing consumers exhibiting the context-effects bias can increase their profits by exploiting their bounded rationality.     

Staying ahead and getting even: Risk attitudes of experienced poker players

Frequent online poker players with extensive experience calculating probabilities and expected values might be expected to behave as Expected Utility maximizers, in that small shocks to their wealth would not affect risk preferences (Rabin, 2000). By contrast, reference-dependent loss aversion (as in Prospect Theory) (Koszegi and Rabin, 2006, Kahneman and Tversky, 1979) predicts that risk aversion decreases as wealth moves away from the reference point in either direction. In terms of continuing to play, as well as a more aggressive playing style, we find strong evidence for the break-even effect, the increased pursuit of risk as a player is losing within a session. Players' behavior also appears consistent with existing evidence on reference-dependent labor supply, in their tendency to reduce effort and risk-taking in response to being ahead. Our findings provide evidence for reference-dependent behavior in a flexible, high-skilled setting, under conditions of well-understood monetary risk.     

Reference-dependent subjective expected utility

A reference-dependent generalisation of subjective expected utility theory is presented. In this theory, preferences between acts depend both on final outcomes and on reference points (which may be uncertain acts). It is characterised by a set of axioms in a Savage-style framework. A restricted form of the theory separates attitudes to end states (encoded in a ‘satisfaction function’) from attitudes to gains and losses of satisfaction. Given weak additional assumptions, the restricted theory excludes cycles of choice, explains observed disparities between willingness-to-pay and willingness-to-accept valuations of lotteries, and predicts preference reversal.     

Money matters: an axiomatic theory of the endowment effect

We develop a framework that allows us to state precisely the relationship between leading concepts of the theoretical and empirical research on reference-dependent preferences, namely the status quo bias, the endowment effect and the willingness to accept (WTA)/willingness to pay (WTP) gap. We show that a monetary version of the status quo bias is a necessary condition for the WTA/WTP gap, and show how to factor out the part of the gap due to income effects from the part of the gap due to the endowment effect. As a byproduct, we show that reference-dependent phenomena are generated by reference-independent factors, i.e., an underlying reference-independent preference relation the properties of which are discussed at length.     

Anticipated regret as an explanation of uncertainty aversion

The paper provides a psychological explanation of uncertainty aversion based on the fear of regret. We capture an agent’s regret using a reference-dependent utility function in which the agent’s utility depends on the performance of his chosen option relative to the performance of the option that would have been best ex post. An uncertain option is represented as a compound lottery. The basic idea is that selecting a compound lottery reveals information, which alters the ex post assessment of what the best choice would have been, inducing regret. We provide sufficient conditions under which regret implies uncertainty aversion in the sense of quasi-concave preferences over compound lotteries.     

Why rationality may be a consequence of Hume's theory of choice

Facing R. Sugden's criticism of our interpretation, it is shown in this paper that rationality appears as a possible consequence of Hume's theory of choice. We first argue that Sugden's dismissal of the preference relation from the type of rationality through which Hume's theory is apprehended, is highly disputable, from the point of view of both standard choice theory and Hume's theory of passions. Nonetheless, Sugden's criterion of rationality might be restated in Humean terms as a condition of non-revision of preferences in the dynamics of passions. But, since the process of choice that we have described explicitly takes into account the revision of preferences, and shows that, when this last is no longer required, rationality occurs as an outcome of this process, it is not really concerned by Sugden's criticism.     

The endowment effect and the reference state: Evidence and manipulations

Recent reports suggest that the “endowment effect” may be due to conditions under which it is observed and explained by incentives long recognized in standard theory. Evidence from new experiments, reported here, provides empirical support for the role of the economic environment on people's perceived reference state and consequently on their valuations, as suggested by Köszegi and Rabin [Köszegi, B., Rabin, M., 2006. A model of reference-dependent preferences. Quarterly Journal of Economics 121, 1133–1165], and indicates that the disappearance of the valuation disparity is more likely due instead to conditions that weaken the perception of reference states. Further, these conditions appear to be poor approximations of those that prevail in most cases for which valuations are normally made.     

When expectations become aspirations: reference-dependent preferences and liquidity constraints

A large body of literature suggests that consumers derive utility from gains and losses relative to a reference point. This paper shows that such reference dependence can affect savings in opposite directions depending on whether people face liquidity constraints. Existing models for wealth and intertemporal choice predict that reference dependence reduces savings, but these models abstract from liquidity constraints. Introducing a liquidity constraint, I find that reference dependence can increase optimal savings for people without access to credit. Ex post, after reference points have been formed, liquidity constraints force consumers to take part of an income loss in early periods, inducing those who are reference dependent to concentrate the full loss in early periods and save in order to eliminate future losses. Further, anticipating a liquidity constraint raises the expected level of future consumption and thus the expectations-based reference point for future periods, creating an ex-ante savings motive. These findings underscore that it is important to account for financial market imperfections when applying or testing reference-dependent models in low-income settings, and potentially explain heterogeneity in how much the poor save when facing binding liquidity constraints.     

Self-rewards and personal motivation

Self-administered rewards are ubiquitous. They serve as incentives for personal accomplishments and are widely recommended to increase personal motivation. We show that in a model with time-inconsistent and reference-dependent preferences, self-rewards can be a credible and effective tool to overcome self-control problems. We also discuss the different types of self-rewards the individual can use, such as vice goods and virtue goods, and analyze which types of goods the individual prefers.