A Model of Reference-Dependent Preferences

TLDR

In deterministic settings, choices maximize consumption utility, but gain‑loss utility shapes behavior under uncertainty. The authors develop a reference‑dependent preferences model where gain‑loss utility derives from consumption utility and the reference point is endogenously set by the economic environment. The model defines reference points as rational expectations of recent outcomes, determined endogenously in a personal equilibrium that aligns expectations with optimal behavior. The model predicts that willingness to pay increases with expected purchase probability and price, and that workers are less likely to continue work after unexpectedly high earnings but more likely to show up and continue when expected income is high.

Abstract

We develop a model of reference-dependent preferences and loss aversion where “gain-loss utility” is derived from standard “consumption utility” and the reference point is determined endogenously by the economic environment. We assume that a person's reference point is her rational expectations held in the recent past about outcomes, which are determined in a personal equilibrium by the requirement that they must be consistent with optimal behavior given expectations. In deterministic environments, choices maximize consumption utility, but gain-loss utility influences behavior when there is uncertainty. Applying the model to consumer behavior, we show that willingness to pay for a good is increasing in the expected probability of purchase and in the expected prices conditional on purchase. In within-day labor-supply decisions, a worker is less likely to continue work if income earned thus far is unexpectedly high, but more likely to show up as well as continue work if expected income is high.