A behavioral theory of the consumer under reference dependent preferences and certainty:∗

We extend classical consumer theory to account for reference dependence and loss aversion under complete certainty. The classical results obtain as a special case. Several new results emergethere is a kink in the demand curve at the reference point, consumers are subject to money illusion, and some kinds of inconsistencies of preferences can be accounted for. However, the reference dependent model does not predict the symmetry of the Hicksian cross partial derivatives, nor the downward slope of Hicksian curves (so the compensated law of demand does not survive), nor the concavity of the expenditure function. We show how several classical results can be modified to take account of reference dependence; these include Shepherd’s Lemma, Roy’s identity, Slutsky equation, and welfare measures such as equivalent and compensating variation. Finally, the classical model underestimates the deadweight loss from taxation; simulations show that this underestimation is by several orders of magnitude. ∗This is an extremely preliminary version of the paper. Not for circulation.