13  Reference dependence

Summary

  • Prospect theory posits that people evaluate choices based on a reference point, coding outcomes as losses or gains relative to this point.
  • Several theories exist for reference point formation, including status quo, lagged consumption, goals, and recent expectations.
  • The status quo as a reference point works well in lab experiments but may not fit many economic interactions or markets with intangible goods.
  • Lagged consumption as a reference point introduces the concept of adaptation, where people react to shocks initially, but the effect fades over time.
  • Goals as reference points explain how people can react differently to the same outcome based on their set objectives.
  • Recent expectations suggests that beliefs about future outcomes form the reference point, potentially aligning with other theories depending on the stability of expectations.

13.1 Introduction

Under prospect theory, people assess choices based on a reference point instead of an absolute assessment of their position. Outcomes are coded as losses and gains relative to that reference point.

Consider the following two scenarios:

  • Scenario 1: You have not checked your share portfolio in a while. You expect it to be worth around $40,000. Today when you check, it is worth $30,000. Do you feel rich or poor?

  • Scenario 2: You have not checked your share portfolio in a while. You expect it to be worth around $20,000. Today when you check, it is worth $30,000. Do you feel rich or poor?

Under expected utility theory, those two scenarios should feel the same as you have U(\$30,000) in both cases.

In contrast, under prospect theory, the value function - value function being what the utility function is typically called in prospect theory - applies to changes relative to the reference point.

If their initial reference point is their expectation, the value of that change is v(\$10,000) or $v(-10,000), depending on whether their expectation is exceeded or not. The importance of that distinction becomes apparent when we examine how people consider choices involving either losses or gains.

13.2 Theories of reference dependence

There are several theories on reference point formation. These include:

  • The status quo
  • Lagged consumption
  • Goals
  • Recent expectations

13.2.1 The status quo

A common assumption in prospect theory is that the reference point is the status quo, as it was for many examples in the original prospect theory paper by Kahneman and Tversky (1979). The status quo implies a preference for the current state. Any negative change is perceived as a loss.

The status quo appears straightforward and is a reasonable description in many contexts, such as lab experiments.

However, the status quo as a reference point does not appear to be a useful assumption for describing many economic interactions. Suppose you decide to sell your bike. Do you see the foregoing of the bike as a loss?

What if you run a bike shop? Does every sale involve a feeling of loss? For markets where intangible and fungible goods are exchanged (for example, the stock market) the status quo assumption appears a poor fit.

13.2.2 Lagged consumption

A second theory is that the reference point is lagged consumption.

Imagine you win the lottery.

How do you feel one week after the draw?

How do you feel one year after the draw?

Your reference point likely reflects more recent consumption.

Lagged consumption introduces adaptation into reference point determination:

  1. First, we react to shocks
  2. Then the effect of the shock fades in time

13.2.3 Goals

Another theory is that our goals are our reference points.

Consider the following problem from Heath et al. (1999):

Sally and Trish both follow workout plans that usually involve doing 25 sit-ups.

One day, Sally sets a goal of performing 31 sit-ups. She finds herself very tired after performing 35 sit-ups and stops.

Trish sets a goal of performing 39 sit-ups. She finds herself very tired after performing 35 sit-ups and stops.

What emotion is each person experiencing?

With goals as reference points, people see success or failure to achieve a goal as a loss or gain. Although both Sally and Trish have the same performance, Sally will have a positive emotional reaction and Trish a negative reaction.

13.2.4 Recent expectations

A fourth theory of reference point determination is recent expectations.

In this approach, the reference point is beliefs about future outcomes (Kőszegi and Rabin (2006)). For example, a 5% pay rise when expecting 10% may be perceived as a loss.

The expectations-based theory can produce the same predictions as alternative theories:

  1. If expectations are stable, recent expectations will reflect the status quo.
  2. Recent consumption will shape expectations, making lagged consumption a reasonable reference point.
  3. Goals can also shape (or be shaped by) expectations