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Loss Aversion and Consumption Plans with Stochastic Reference Points

Author

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  • Park Hyeon

    (Department of Economics and Finance, Manhattan College, 4513 Manhattan College Pkwy, Riverdale, NY 10471, USA)

Abstract

This paper studies the making of risky choices following loss aversion with endogenous reference expectations under the two schemes of state-independent and state-dependent stochastic reference points. Using a tractable, intertemporal choice model, this paper derives analytic solutions to show that, when loss aversion is high, the reference-dependent decision maker saves a markedly larger amount than is predicted by the standard model. When the loss aversion is low (i.e. the individual is loss-tolerant), the overall result is ambiguous, although the decision maker may deviate into consuming more; if he faces a small level of uncertainty relative to the intensity of his loss aversion, he may even do this by borrowing. Given the same loss aversion level, this study determines that, in the presence of positive state-dependence, the state-independent model generates greater deviation than the state-dependent one. Finally, this paper derives a two-period general equilibrium result with two agents who have different attitudes toward loss.

Suggested Citation

  • Park Hyeon, 2016. "Loss Aversion and Consumption Plans with Stochastic Reference Points," The B.E. Journal of Theoretical Economics, De Gruyter, vol. 16(1), pages 303-336, January.
    • Handle: RePEc:bpj:bejtec:v:16:y:2016:i:1:p:303-336:n:9
    DOI: 10.1515/bejte-2014-0100
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    References listed on IDEAS

    as
    1. Pagel, Michaela, 2013. "Expectations-Based Reference-Dependent Life-Cycle Consumption," MPRA Paper 47138, University Library of Munich, Germany.
    2. Siegmann, Arjen, 2002. "Optimal saving rules for loss-averse agents under uncertainty," Economics Letters, Elsevier, vol. 77(1), pages 27-34, September.
    3. Philippe Delquié & Alessandra Cillo, 2006. "Disappointment without prior expectation: a unifying perspective on decision under risk," Journal of Risk and Uncertainty, Springer, vol. 33(3), pages 197-215, December.
    4. David Freeman, 2013. "Revealed Preference Foundations of Expectations-Based Reference-Dependence," Discussion Papers dp13-10, Department of Economics, Simon Fraser University.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    loss aversion; reference-dependent preference; stochastic reference point; precautionary saving;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D91 - Microeconomics - - Micro-Based Behavioral Economics - - - Role and Effects of Psychological, Emotional, Social, and Cognitive Factors on Decision Making
    • C60 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - General
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth

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