A Model of Reference-Dependent Preferences*

Abstract

We develop a model that fleshes out, extends, and modifies existing models of reference dependent preferences and loss aversion while accomodating 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.