ABSTRACT
Instead of exhibiting standard reference-independent preferences, empirical evidence points to the plausible alternative that individuals code outcomes as gains or losses. This chapter introduces a nonstandard model of reference-dependent preferences with loss aversion. The utility function depends not only on the final outcome, but on a point of reference. This reference point might be a function of past outcomes or future expectations. With loss aversion, losses loom larger than equivalent gains. The model is sufficiently general to be applied across a wide range of settings, with and without certainty. It can make sense of the endowment effect, seemingly absurd risk preferences, and the equity premium puzzle (with myopic loss aversion). The chapter concludes with evidence of income targeting in labor markets, job search during unemployment, and life-cycle consumption (with news utility) that can each be explained by the new model.
