Toward an Information-Processing Theory of Loss Aversion

This paper considers a model where a risk-neutral individual can receive both a signal about whether an outcome is above a certain threshold (a reference point) and a continuous signal on the value of the outcome. The paper shows that, given the existence of these two signals for an outcome, the expected value function of the outcome exhibits diminishing sensitivities both above and below the reference point. Furthermore, in the examples considered, loss aversion occurs if the reference point is not too high. The paper shows how the informativeness of each signal affects the declining sensitivities and loss aversion effects and how the model reduces to risk-neutral decision making when the continuous signal on the value of the outcome is perfectly informative. The loss aversion effects occur for low reference points because the reference point is below the expected value of the outcome and because of the greater likelihood of receiving the signal that the outcome is above the reference point. The paper obtains the same result in a rational inattention framework because the individual may pay greater attention to the less likely low outcomes.