Loss Aversion and Consumption Plans with Stochastic Reference Points

Abstract

AbstractThis 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.