We develop a model that fleshes out, extends, and modifies existing models of referencedependent preferences and loss aversion while accomodating most of the evidence motivating these models. Our approach makes reference-dependent theory more broadly applicable by avoiding some of the ways that prevailing models—if applied literally and without ancillary assumptions—make variously weak and incorrect predictions. Our model combines the reference-dependent gain-loss utility with standard economic “consumption utility ” and clarifies the relationship between the two. Most importantly, we posit that a person’s reference point is her recent expectations about outcomes (rather than the status quo), and assume that behavior accords to a personal equilibrium: The person maximizes utility given her rational expectations about outcomes, where these expectations depend on her own anticipated behavior. We apply our theory to consumer behavior, and emphasize that a consumer’s willingness to pay for a good is endogenously determined by the market distribution of prices and how she expects to respond to these prices. Because a buyer’s willingness to buy depends on whether she anticipates buying the good, for a range of market prices there are multiple personal equilibria. This multiplicity disappears when the consumer is sufficiently uncertain about the price she will face. Because paying more than she anticipated induces a sense of loss in the buyer, the lower the prices at which she expects to buy the lower will be her willingness to pay. In some situations, a known stochastic decrease in prices can even lower the quantity demanded.

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Subjects judged the values of lotteries from 3 points of view: the highest price that a buyer should pay, the lowest price that a seller should accept, and the "fair " price. The rank order of judgments changed as a function of point of view. Data also showed violations of branch independence and monotonicity (dominance). These findings pose difficulties for nonconfigural theories of decision making, such as subjective expected utility theory, but can be described by configural-weight theory. Configural weighting is similar to rank-dependent utility theory, except that the weight of the lowest outcome in a gamble depends on the viewpoint, and 0-valued outcomes receive differential weighting. Configural-weight theory predicted the effect of viewpoint, the violations of branch independence, and the violations of monotonicity, using a single scale of utility that is independent of the lottery and the point of view. In order to study how people evaluate and choose among alternatives, experimental psychologists have investigated judgments of lotteries. With lotteries, one can manipulate what appear to be crucial ingredients in judgment and decision making: the alternatives, the outcomes, and probabilities of the outcomes. Gambles therefore seem to provide a fruitful paradigm for the investigation of decisions (Edwards, 1954;

We provide a formal treatment of both static and dynamic portfolio choice using the Disappointment Aversion preferences of Gul (1991. Econometrica 59(3), 667–686), which imply asymmetric aversion to gains versus losses. Our dynamic formulation nests the standard CRRA asset allocation problem as a special case. Using realistic data generating processes, we find reasonable equity portfolio allocations for disappointment averse investors with utility functions exhibiting low curvature. Moderate variation in parameters can robustly generate

Because players whose preferences violate the von Neumann-Morgenstern independence axiom may be unwilling to randomize as mixed-strategy Nash equilibrium would require, a Nash equilibrium may not exist without independence. This paper generalizes Nash’s definition of equilibrium, retaining its rationalexpectations spirit but relaxing its requirement that a player must bear as much uncertainty about his own strategy choice as other players do. The resulting notion, “equilibrium in beliefs, ” is equivalent to Nash equilibrium when independence is satistied, but exists without independence. This makes it possible to study the robustness of equilibrium comparative statics results to violations of independence. Jotuna / of ’ Gononric, Lirerarurr Classification Numbers: 022, 026. ” 1990 Academic Press. inc. 1.

This paper integrates models of atemporal risk preference that relax the independence axiom, into a recursive intertemporal asset-pricing framework. The resulting models are amenable to empirical analysis using market data and standard Euler equation methods. We are thereby able to provide the first nonlaboratory-based evidence regarding the usefulness of several new theories of risk preference for addressing standard problems in dynamic economics. Using both stock and bond returns data, we find that a model incorporating risk preferences that exhibit first-order risk aversion accounts for significantly more of the mean and autocorrelation properties of the data than models that exhibit only second-order risk aversion.

This paper contributes to an important recent debate around expected utility and risk aversion. Rejecting a gamble over a given range of wealth levels imposes a lower bound on risk aversion. Using this lower bound and empirical evidence on the range of the risk aversion coefficient, we calibrate the relationship between risk attitudes over small-stakes and large-stakes gambles. We find that rejecting small gambles is consistent with expected utility, contrary to a recent literature that concludes that expected utility is fundamentally unfit to explain decisions under uncertainty. Paradoxical behavior is only obtained when calibrations are made in a region of the parameter space that is not empirically relevant. JEL Classification: D00, D80, D81.

Much research on judgment and decision making has focussed on the adequacy of classical rationality as a description of human reasoning. But more recently it has been argued that classical rationality should also be rejected even as normative standards for human reasoning. For example, Gigerenzer and Goldstein (1996) and Gigerenzer and Todd (1999a) argue that reasoning involves ‘‘fast and frugal’ ’ algorithms which are not justified by rational norms, but which succeed in the environment. They provide three lines of argument for this view, based on: (A) the importance of the environment; (B) the existence of cognitive limitations; and (C) the fact that an algorithm with no apparent rational basis, Take-the-Best, succeeds in an judgment task (judging which of two cities is the larger, based on lists of features of each city). We reconsider (A)–(C), arguing that standard patterns of explanation in psychology and the social and biological sciences, use rational norms to explain why simple cognitive algorithms can succeed. We also present new computer simulations that compare Take-the-Best with other cognitive models (which use connectionist, exemplarbased, and decision-tree algorithms). Although Take-the-Best still performs well, it does not perform noticeably better than the other models. We conclude that these results provide no strong reason to prefer Take-the-Best over alternative cognitive models.

Rabin [17] proved that a low level of risk aversion with respect to small gambles leads to a high, and absurd, level of risk aversion with respect to large gambles. Rabin’s arguments strongly depend on expected utility theory, but we show that similar arguments apply to many non-expected utility theories. 1

In order to investigate derived scales for the utility, or subjective value of money, subjects were instructed to perform four tasks: in two tasks, they judged “ratios” and “differences” of strengths of preference for monetary amounts; in two other tasks, they judged the values of gambles from buyer’s or seller’s points of view. The two arrays of data for “ratios” and “differences” were consistent with the hypothesis that most subjects used only one operation to compare monetary amounts, although a few subjects appeared to use two operations. The buyer’s and seller’s prices would lead to two different utility functions for money under expected utility theory, subjective expected utility theory, or any theory that is additive across outcomes. However, configural-weight utility theory can predict these changes in rank order with an invariant utility function, by postulating that the configural weight of the smaller amount depends on point of view. The data also reveal systematic violations of dominance (monotonicity) that can be described by assuming that the configural weight of zero, when it is the lower value, has smaller weight at low probabilities than nonzero outcomes. Disregarding the minority of subjects who appeared to utilize two operations for judging “ratios ” and “differences” in utility, the majority of the data can be well-approximated using a single scale of utility, the subtractive model for “ratio” and “difference” comparisons, and the configurai weight, rank-dependent model for buyer’s and seller’s prices.