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Price expectations and reference-dependent preferences
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oTree is an open-source and online software for implementing interactive experiments in the laboratory, online, the field or combinations thereof. oTree does not require installation of software on subjects’ devices; it can run on any device that has a web browser, be that a desktop computer, a tablet or a smartphone. Deployment can be internet-based without a shared local network, or local-network-based even without internet access. For coding, Python is used, a popular, open-source programming language. http://www.oTree.org[www.oTree.org] provides the source code, a library of standard game templates and demo games which can be played by anyone.
A key open question for theories of reference-dependent preferences is: what determines the reference point? One candidate is expectations: what people expect could affect how they feel about what actually occurs. In a real-effort experiment, we manipulate the rational expectations of subjects and check whether this manipulation influences their effort provision. We find that effort provision is significantly different between treatments in the way predicted by models of expectation-based, reference-dependent preferences: if expectations are high, subjects work longer and earn more money than if expectations are low. (JEL D12, D84, J22)
We develop a novel computerized real effort task, based on moving sliders across a screen, to test experimentally whether agents are disappointment averse when they compete in a real effort sequential-move tournament. We predict that a disappointment averse agent, who is loss averse around her endogenous choice-acclimating expectations-based reference point, responds negatively to her rival's effort. We find significant evidence for this discouragement effect, and use the Method of Simulated Moments to estimate the strength of disappointment aversion on average and the heterogeneity in disappointment aversion across the population. (JEL C91, D12, D81, D84)
Loss aversion can occur in riskless and risky choices. Yet, there is no evidence whether people who are loss averse in riskless choices are also loss averse in risky choices. We measure individual-level loss aversion in riskless choices in an endowment effect experiment by eliciting both WTA and WTP from each of our 360 subjects (randomly selected customers of a car manufacturer). All subjects also participate in a simple lottery choice task which arguably measures loss aversion in risky choices. We find substantial heterogeneity in both measures of loss aversion. Loss aversion in the riskless choice task and loss aversion in the risky choice task are highly significantly and strongly positively correlated. We find that in both choice tasks loss aversion increases in age, income, and wealth, and decreases in education.
We modify the Salop (1979) model of price competition with differentiated products by assuming that consumers are loss averse relative to a reference point given by their recent expectations about the purchase. Consumers' sensitivity to losses in money increases the price responsiveness of demand—and hence the intensity of competition—at higher relative to lower market prices, reducing or eliminating price variation both within and between products. When firms face common stochastic costs, in any symmetric equilibrium the markup is strictly decreasing in cost. Even when firms face different cost distributions, we identify conditions under which a focal-price equilibrium (where firms always charge the same "focal" price) exists, and conditions under which any equilibrium is focal. (JEL D11 , D43, D81, L13)
What explains the mixed evidence from laboratory tests of Kőszegi and Rabin’s (2006 and later) model of expectations-based reference-dependent preferences? We investigate one hypothesis: to become (behavior-affecting) reference points, probability beliefs have to sink in—being merely lagged, as the theory requires, is not sufficient. Past experiments with conflicting findings exogenously endowed subjects with beliefs that were equally lagged, but possibly unequally sunk-in. In four experiments, whose designs replicate past KR-nonsupporting experiments, we add new sink-in manipulations that endow individuals with additional, visual/physical probability impressions. Our findings are more KR-supporting in an endowment-effect setting but not in an effort-provision setting.
A key prediction of expectations-based reference-dependent preferences and loss aversion in second-price auctions with private values is that the number of bidders should affect bids in auctions for real objects but not in auctions with induced monetary values. In order to test this distinctive comparative statics prediction, we develop an experiment where subjects bid in multiple auctions for real objects as well as auctions with induced values, each time facing a different number of rivals. Our results are broadly consistent with expectations-based reference-dependent preferences and loss aversion. We find that in real-object auctions bids decline with the intensity of competition whereas in induced-value auctions, instead, bids do not vary with the intensity of competition. Our results suggest that bidders may behave differently in real-object auctions than in induced-value ones, casting some doubt on the extent to which findings from induced-value laboratory experiments can be transferred to the field.
We test expectations-based reference dependence in market experiments with probabilistic forced exchange. Koszegi and Rabin (2006 ) predict that when the probability of forced exchange increases, individuals cannot expect to stick with the status quo, and should grow more willing to exchange. This mechanism may eliminate and even reverse the "endowment effect" (Knetsch and Sinden 1984; Kahneman, Knetsch, and Thaler 1990 ). In a series of experiments with overall 930 subjects, we show some tentative support for the notion that attitudes toward exchange are influenced by the probability of forced exchange. However, the results are sensitive to small changes in experimental design.
In this chapter, we present theories and applications of reference-dependent preferences. We provide some historical perspective, but also move quickly to the current research frontier, focusing on developments in reference dependence over the last 20 years. We present a number of worked examples to highlight the broad applicability of reference dependence. While our primary focus is gain–loss utility, we also provide a short treatment of probability weighting and its links to reference dependence.
Theories of expectations-based reference-dependent preferences have provided a critical modeling innovation, incorporating a structured theory of the formation of reference points. An important prediction of these models is a monotone response in behavior to changes in expectations. To test such models we conduct a real-effort experiment manipulating expectations and examining consequences on effort provision. In contrast to the theory, we document substantial nonmonotonicities in the effort response to changing expectations. Our results provide some evidence on the limitations of expectations-based reference dependence. (JEL: D81, D84, D12, D03)
Another social science looks at itself
Experimental economists have joined the reproducibility discussion by replicating selected published experiments from two top-tier journals in economics. Camerer et al. found that two-thirds of the 18 studies examined yielded replicable estimates of effect size and direction. This proportion is somewhat lower than unaffiliated experts were willing to bet in an associated prediction market, but roughly in line with expectations from sample sizes and P values.
Science , this issue p. 1433
In this article, the authors propose some psychological principles to describe the boundaries of loss aversion. A key idea is that exchange goods that are given up "as intended" do not exhibit loss aversion. For example, the authors propose that money given up in purchases is not generally subject to loss aversion. The results of several experiments provide preliminary support for the hypotheses. The authors find that, consistent with prospect theory, loss aversion provides a complete account of risk aversion for risks with equal probability to win or lose. The authors propose boundaries for this result and suggest further tests of the model.
This paper discusses aspects of recruiting subjects for economic laboratory experiments, and shows how the Online Recruitment System for Economic Experiments can help. The software package provides experimenters with a free, convenient, and very powerful tool to organize their experiments and sessions.
I show theoretically that applying the model of Kőszegi and Rabin (2006) to a simple purchasing decision where consumers are ex-ante uncertain about the price realisation, gives - when changing the underlying distribution of expected prices - rise to counterintuitive predictions in contrast with a “good deal model” where consumers are predicted to be disappointed (rejoice) when the realised price is perceived as being worse (better) than the other possible realisation. While the underlying ideas of both models are similar with respect to expectation-based reference points, the different results come from the concept of Personal Equilibrium in Kőszegi and Rabin (2006). The experimental results show some support for the simpler good deal model for a number of different real consumption goods though the support is weaker for goods that either have a salient market price or no market price outside of the experiment.
I characterize the pro…t-maximizing pricing and product-availability strategies for a re-tailer selling two substitute goods to loss-averse consumers. Consumers have unit demand, are interested in buying at most one good, and their reference point is given by their recent rational expectations about what consumption value they would receive and what price they would pay. If the goods are close substitutes, the seller maximizes pro…ts by creating an "at-tachment e¤ect" for the consumers through a tempting discount on a good available only in limited supply (the bargain) and cashing in with a high price on the other good (the rip-o¤). Consumers are enticed by the possibility of getting a bargain, but, if it is not there, they buy a substitute good as a means of minimizing disappointment. The seller tends to use the more valuable product as a bargain because consumers feel a larger loss, in terms of forgone consumption, if this item is not available and are hence willing to pay a larger premium to reduce uncertainty in their consumption. I also show that the bargain can be priced below marginal cost, that the seller's product mix di¤ers from the welfare-maximizing one and that she might supply a socially wasteful product. JEL classi…cation: D11; D42; L11.
A hallmark result within behavioral economics is that individuals' choices are affected by current endowments. A recent theory due to Kőszegi and Rabin (, Quarterly Journal of Economics, 121, 1133–1165) explains such endowment effect with a model of expectations-based reference-dependent preferences. Departing from past work, we conduct complementary experiments to disentangle expectations—verified probabilistic beliefs held by subjects—from other features of endowment—such as “assignment” to a good—hence allowing us to compare the effect of expectations with that of other variations. While mere assignment can affect choices, we do not find a large role in the effect for Kőszegi–Rabin expectations.
A central assumption of neoclassical economics is that reservation prices for familiar products express people’s true preferences for these products, that is, they represent the total benefit that a good confers to the consumers, and are thus, independent of actual prices in the market. Nevertheless, a vast amount of research has shown that valuations can be sensitive to other salient prices; particularly when individuals are explicitly anchored on them. In this paper, the authors extend previous research on single-price anchoring and study the sensitivity of valuations to the distribution of prices found for the product in the market. In addition, they examine its possible causes. They find that market-dependent valuations cannot be fully explained by rational inferences consumers draw about a product’s value, and are unlikely to be fully explained by true market-dependent preferences. Rather, the market dependence of valuations likely reflects consumers’ focus on something other than the total benefit that the product confers to them. Furthermore, this paper shows that market-dependent valuations persist when – as in many real-life settings – individuals make repeated purchase decisions over time and infer the distribution of the product’s prices from their market experience. Finally, the authors consider the implications of their findings for marketers and consumers.
We provide a novel experimental auction design, in which (i) an exogenous decrease in the probability of winning, conditional on the bid, reduces the optimal bid of a loss averse agent whose reference point is expectations based; (ii) observed bid distributions uniquely identify the participants' latent value distribution and loss-aversion parameter. Experimental evidence affirms the presence of such reference points. We show that at the estimated magnitudes of loss aversion, (a) conventional Becker, DeGroot, and Marschak (1964) experiments may lead to large biases in estimated willingness to pay (which our design can correct for); and (b) first-price auctions may fetch moderately higher revenue, compared with second-price auctions.
Evidence on loss aversion and the endowment effect suggests that people evaluate outcomes with respect to a reference point. Yet little is known about what determines reference points. This experiment shows that expectations determine reference points. We endow subjects with an item and randomize the probability they will be allowed to trade it for an alternative. Subjects that are less likely to be able to trade are more likely to choose to keep their item, as predicted when reference points are determined by expectations, but not when reference points are determined by the status quo or when preferences are reference-independent.
The endowment effect has been widely documented. Recent models of reference-dependent preferences indicate that expectations play a prominent role in the presence of the phenomenon. A subset of such expectations-based models predicts an endowment effect for risk when reference points change from certain to stochastic. In two purposefully simple risk preference experiments, eliminat-ing often-discussed confounds, I demonstrate both between and within-subjects an endowment effect for risky gambles. While subjects are virtually risk neutral when choosing between fixed gambles and changing certain amounts, a high de-gree of risk aversion is displayed when choosing between fixed amounts and chang-ing gambles. These results provide needed separation between expectations-based reference-dependent models, allow for evaluation of recent theoretical ex-tensions, and may help to close a long-standing debate in decision science on inconsistency between probability and certainty equivalent methodology for util-ity elicitation.
Within the expected-utility framework, the only explanation for risk aversion is that the utility function for wealth is concave: A person has lower marginal utility for additional wealth when she is wealthy than when she is poor. This paper provides a theorem showing that expected-utility theory is an utterly implausible explanation for appreciable risk aversion over modest stakes: Within expected-utility theory, for any concave utility function, even very little risk aversion over modest stakes implies an absurd degree of risk aversion over large stakes. Illustrative calibrations are provided. Keywords: Diminishing Marginal Utility, Expected Utility, Risk Aversion JEL Classifications: B49, D11, D81 Acknowledgments: Many people, including David Bowman, Colin Camerer, Eddie Dekel, Larry Epstein, Erik Eyster, Mitch Polinsky, Drazen Prelec, Richard Thaler, and Roberto Weber, as well as Andy Postlewaite and two anonymous referees, have provided useful feedback on this paper. I th...
A person deciding on a career, a wife, or a place to live bases his choice on two factors: (1) How much do I like each of the available alternatives? and (2) What are the chances for a successful outcome of each alternative? These two factors comprise the utility of each outcome for the person making the choice. This notion of utility is fundamental to most current theories of decision behavior. According to the expected utility hypothesis, if we could know the utility function of a person, we could predict his choice from among any set of actions or objects. But the utility function of a given subject is almost impossible to measure directly. To circumvent this difficulty, stochastic models of choice behavior have been formulated which do not predict the subject's choices but make statements about the probabilities that the subject will choose a given action. This paper reports an experiment to measure utility and to test one stochastic model of choice behavior.
We develop a rational dynamic model in which people are loss averse over changes in beliefs about present and future consumption. Because changes in wealth are news about future consumption, preferences over money are reference-dependent. If news resonates more when about imminent consumption than when about future consumption, a decision maker might (to generate pleasant surprises) overconsume early relative to the optimal committed plan, increase immediate consumption following surprise wealth increases, and delay decreasing consumption following surprise losses. Since higher wealth mitigates the effect of bad news, people exhibit an unambiguous first-order precautionary-savings motive. (JEL D14, D81, D83, D91)
Several experimental studies have reported that an otherwise robust regularity—the disparity between Willingness-To-Accept
and Willingness-To-Pay—tends to be greatly reduced in repeated markets, posing a serious challenge to existing reference-dependent and reference-independent models alike. This article offers a new account of the evidence, based on the assumptions that individuals are affected by
good and bad deals relative to the expected transaction price (price sensitivity), with bad deals having a larger impact on their utility (`bad-deal’ aversion). These features of preferences explain the existing evidence better than alternative approaches, including the most recent
developments of loss aversion models.
KeywordsWTA/WTP disparity–Price sensitivity–Bad-deal aversion–Vickrey auctions–Reference-dependence–Loss aversion
This paper reformulates and simplifies a recent model by Heidhues and Kőszegi (The impact of consumer loss aversion on pricing,
Mimeo, 2005), which in turn is based on a behavioral model due to Kőszegi and Rabin (Q J Econ 121:1133–1166, 2006). The model analyzes optimal pricing when consumers are loss averse in the sense that an unexpected price hike lowers their
willingness to pay. The main message of the Heidhues–Kőszegi model, namely that this form of consumer loss aversion leads
to rigid price responses to cost fluctuations, carries over. I demonstrate the usefulness of this “cover version” of the Heidhues–Kőszegi-Rabin
model by obtaining new results: (1) loss aversion lowers expected prices; (2) the firm’s incentive to adopt a rigid pricing
strategy is stronger when fluctuations are in demand rather than in costs.
KeywordsLoss aversion–Monopoly pricing–Cover version
This article concerns the nonparametric Fisher-Pitman tests for paired replicates and independent samples. After outlining the theory of exact tests, I derive Monte Carlo simulations for both of them. Simulations can be useful if one deals with many observations because of the complexity of the algorithms in regard to sample sizes. The tests are designed to be a more powerful alternative to the Wilcoxon signed-rank test and the Wilcoxon-Mann-Whitney rank-sum test if the observations are given on at least an interval scale. The results gained by Monte Carlo versions of the tests are accurate enough in comparison to the exact versions. Finally, I give examples for using both supplemented tests. Copyright 2007 by StataCorp LP.
We use Koszegi 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)
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.
Analysis of decision making under risk has been dominated by expected utility theory, which generally accounts for people's actions. Presents a critique of expected utility theory as a descriptive model of decision making under risk, and argues that common forms of utility theory are not adequate, and proposes an alternative theory of choice under risk called prospect theory. In expected utility theory, utilities of outcomes are weighted by their probabilities. Considers results of responses to various hypothetical decision situations under risk and shows results that violate the tenets of expected utility theory. People overweight outcomes considered certain, relative to outcomes that are merely probable, a situation called the "certainty effect." This effect contributes to risk aversion in choices involving sure gains, and to risk seeking in choices involving sure losses. In choices where gains are replaced by losses, the pattern is called the "reflection effect." People discard components shared by all prospects under consideration, a tendency called the "isolation effect." Also shows that in choice situations, preferences may be altered by different representations of probabilities. Develops an alternative theory of individual decision making under risk, called prospect theory, developed for simple prospects with monetary outcomes and stated probabilities, in which value is given to gains and losses (i.e., changes in wealth or welfare) rather than to final assets, and probabilities are replaced by decision weights. The theory has two phases. The editing phase organizes and reformulates the options to simplify later evaluation and choice. The edited prospects are evaluated and the highest value prospect chosen. Discusses and models this theory, and offers directions for extending prospect theory are offered. (TNM)
Regular prices and sales
- Heidhues
A reference price theory of the endowment effect
- Weaver
De gustibus” and disputes about reference dependence
- P Campos-Mercade
- L Goette
- T Graeber
- A Kellogg
- C Sprenger