Concepedia

Reference-Dependent Risk Attitudes

American Economic Review · 2007 · 1.1K citations · 37 references

TL;DR

The study applies Kőszegi and Rabin’s reference‑dependent utility model, extended to delayed outcomes, to analyze monetary risk preferences. The authors employ this model to examine how reference points and delayed consequences shape risk attitudes. The model predicts that unexpected risk exposure reproduces prospect theory’s loss aversion, while anticipated risk induces first‑order risk aversion and prior risk expectations lower aversion to both anticipated and additional risk, and for large‑scale risk consumption utility dominates, yielding similar risk aversion across situations. JEL classification: D81.

Abstract

We use Kőszegi 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)