A Model of Reference-Dependent Preferences

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…