The Welfare Economics of Reference Dependence

Empirical evidence suggests that individuals often evaluate options relative to a reference point, especially seeking to avoid losses. We undertake the first welfare analysis under reference-dependent preferences. We characterize the welfare impact of changes in reference points and prices, decomposing these into direct and behavioral effects. The sign of direct and behavioral effects depends on the form of reference-dependent payoffs; which of these effects matter for welfare depends on whether reference dependence reflects a bias or a normative preference. We derive sufficient statistics formulas quantifying the social welfare effects of changes in reference points and prices in terms of estimable reduced-form parameters and normative judgments. We illustrate these findings with an empirical application to reference dependence exhibited in German workers’ retirement decisions. We find positive social welfare effects of increasing the Normal Retirement Age, but ambiguous effects of financial incentives to postpone retirement.