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Reference Effect: Contrasting Reference-dependent Models

Reference Effect: Contrasting Reference-dependent Models. Y. Masatlioglu and N. Uler University of Michigan. Do Reference Points Influence Economic Outcomes?. Standard Neoclassical Theory:

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Reference Effect: Contrasting Reference-dependent Models

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  1. Reference Effect: Contrasting Reference-dependent Models Y. Masatlioglu and N. Uler University of Michigan

  2. Do Reference Points Influence Economic Outcomes? • Standard Neoclassical Theory: If transactions costs are small enough, reference points should not influence rational consumers. • In practice, defaults make an enormous difference: • Organ donation • Car insurance • Car purchase options • Consent to receive e-mail marketing • Savings • Asset allocation Moscow 2009

  3. Reference-Dependent Behavior • Endowment Effect The gap between WTA and WTP • Status Quo Bias People often stick with their default options • Reference Effect Reference points alter one's choices even when agents do not stick to the reference point itself

  4. The Reference Effect STATUS QUO BIAS x is more likely to be chosen from the set {x, y} when x is the endowment, REFERENCE EFFECT x is more likely to be chosen from the set {x, y, r} when there is an endowment, r. Good 2 y x r Good 1

  5. Reference-Dependent Models • Behavioral Models (Positive Approach) Tversky and Kahneman (1991) • Rational Models (Normative Approach) Masatlioglu and Ok (2005, 2007, 2009)

  6. Tversky and Kahneman (1991)(Loss Aversion Model (LA)) • Reference dependence • Loss aversion • Diminishing sensitivity concave for a > 0, convex for a < 0

  7. Shortcomings of the LA model • Non-convex Indifference Curves • Unusual Cyclical Choices • Accommodates not only Status Quo Bias but also Status Quo Aversion Moscow 2009

  8. Unusual Preference Cycles Munro and Sugden (2003) show that one can find three alternatives, x, y and z such that Moscow 2009

  9. Loss Aversion Model predicts Status Quo Aversion EXAMPLE: Consider an environment in which an agent needs to choose among pairs (x,m), where x and m stand for the units of a private good and money, respectively. Choose between “one mug and $100” and “no mug and $103” when there is no reference: Now, status quo is “one mug and $100” what would you do? STATUS QUO AVERSION !!! Moscow 2009

  10. Constant Loss Aversion (CLA) • We say Constant Loss Aversion if there is no diminishing sensitivity or constant sensitivity (gi is linear). • While Loss Aversion Model • permits non-convex indifference curves and intransitive preferences • accommodates not only status quo bias but also status quo aversion, • While Constant Loss Aversion does not suffer from these implications, it is much more restrictive than the LA model. Moscow 2009

  11. The Multi-criteria Choice ModelMasatlioglu and Ok (2005) If y is chosen when x is the status quo point, then, y must be chosen when y is itself the status quo. Axiom of Status Quo Bias Moscow 2009

  12. u1 u2 Masatlioglu and Ok, 2005 (The SQB Model) Sports Assume that r is the status quo Acceptable alternatives when r is status quo r2 r U = w1u1+w2u2 Movie r1 Moscow 2009

  13. Loss Aversion vs. Status Quo Bias • Loss Aversion Model • Status Quo Bias Model Moscow 2009

  14. The Generalized SQB ModelMasatlioglu and Ok (2009) Mental Constraint such that Moscow 2009

  15. The Procedural RD Model Masatlioglu and Ok (2007) Another generalization of SQB model with two mental constraints, Q1and Q2 such that

  16. Some Facts about Experiment • Conducted at C.E.S.S. (NYU) • A total of 99 subjects • Money and Chocolate • Each subject answered 16 questions • On average, earned $14 including the $7 show-up fee and also some chocolates

  17. Experimental Design Belgium Chocolate y x r1 r7 r5 r3 r2 r6 r4 r0 Money

  18. A Screen Shot from the Experiment

  19. Experimental Design: Theoretical Predictions Assume that y is preferred to x when there is no reference point. There are four possible cases: Good 2 y x r1 r2 r0 Good 1 Moscow 2009

  20. Loss Aversion Model Good 2 LA model favors x y x r1 r2 Good 1

  21. u1 u1 u2 u2 SQB Model Good 2 y SQB model favors y x r1 r2 Good 1

  22. Generalized SQB Model Good 2 y GSQB model is indecisive x Q(r1) r1 Q(r2) r2 Good 1

  23. Procedural R-D Model Good 2 Q1(r1) y Q1(r2) PRD model is also indecisive x Q2(r1) r1 Q2(r2) r2 Good 1

  24. Theoretical Predictions for r1 r2 Belgium Chocolate y x r1 r2 r0 Money

  25. Theoretical Predictions y x r1 r7 r5 r3 r2 r6 r4 r0

  26. Reference Effect: Preference Reversals

  27. Comparison of the Models Explanatory Power of the Models (in percentages)

  28. Selten’s Measure of Predictive Success

  29. Conclusion • Existence of the reference effect • An experiment that distinguish between the models of reference-dependence. • R-D Models make different predictions regarding the reference effect. • We find that both the PRD and LA models explain approximately 90 percent of the data.

  30. THANK YOU Moscow 2009

  31. Moscow 2009

  32. A Sample Question from the Experiment

  33. Is SQB Axiom too strong? Take x = CUNY, y = OSU and z = UM OSU = c({CUNY, OSU},CUNY) UM = c({OSU, UM},OSU) But CUNY = c({CUNY, UM},CUNY) Moscow 2009

  34. Relaxing SQB Axiom? Weak Status Quo Bias implies and implies Moscow 2009

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