A Model of Reference-Dependent Preferences

We develop a model that fleshes out, extends, and modifies existing models of referencedependent preferences and loss aversion, with the goal of making the theory more broadly applicable. Our model 1) allows for stochastic reference points; 2) accommodates a realistic form of flexibility in the “psychological dimensions” relevant for evaluating gains and losses; 3) combines the reference-dependent “gain-loss” utility with standard economic “consumption utility” and clarifies the relationship between the two; and most importantly, 4) bases the reference point on the decisionmaker’s probabilistic beliefs about what she’ll end up with rather than the status quo. Our model assumes that behavior accords to a personal equilibrium: An agent maximizes given her rational expectations about outcomes, where her beliefs about the outcomes depend on her own planned behavior. We discuss how our model helps explain both existing evidence and examples, and examples not previously discussed in the literature. We apply our model to simple buying and selling situations. Since a buyer’s reservation price depends on whether she anticipates buying the good, for a range of price levels, there are multiple personal equilibria. Moreover, because the amount a buyer is willing to pay depends on how much she anticipates paying, the lower the prevailing market prices the lower will be a consumer’s reservation price. As a result, a stochastic decrease in prices can lower the quantity demanded. Finally, we show that in market equilibrium the buyer’s reservation price tends to be lower than that of a seller with identical preferences—despite the fact that our model accords no direct role for initial endowments.