Rational Choice with Category Bias

This paper develops, using the revealed preference approach, a model of choice with an initial endowment and in the presence of alternatives that are grouped into categories. Our model generalizes the classical individual choice model which is rationalized by utility maximization, and reduces to that model in the absence of an initial endowment. Given an exogenous endowment, our decision maker follows a 3-step procedure: First, she identifies the best alternative in the choice set which belongs to the same category as her endowment. This alternative serves as her endogenous reference point which in turn, at the second step, induces a “psychological constraint”. Finally, she chooses the best feasible alternative in her constraint set according to her reference-free utility. The model gives rise to a “category bias” which generalizes the status quo bias by attracting the decision maker towards the endowment’s category but not necessarily towards the endowment itself. It also accommodates recent experimental findings on the absence of status quo bias among goods which belong to the same category. We apply the model to a financial choice problem and show that category bias may lead to a risk premium even with risk neutral agents.