Y. Masatlioglu and N. Uler

University of Michigan

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

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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

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The Reference Effect

4

r

y

x

Good 1

Goo

d 2 STATUS QUO BIAS

x is more likely to bechosen from the set {x, y} when x is the endowment,

REFERENCE EFFECTx is more likely to bechosen from the set {x, y, r} when there is an endowment, r.

Reference-Dependent Models

• Behavioral Models (Positive Approach)Tversky and Kahneman (1991)

• Rational Models (Normative Approach)Masatlioglu and Ok (2005, 2007, 2009)

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Tversky and Kahneman (1991)(Loss Aversion Model (LA))

• Reference dependence

• Loss aversion

• Diminishing sensitivity

)]()([)( iii

iii ruxugxrU

][][ agag ii

6

ig concave for a > 0, convex for a < 0

Shortcomings of the LA model

• Non-convex Indifference Curves

• Unusual Cyclical Choices

• Accommodates not only Status Quo Bias but also Status Quo Aversion

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Unusual Preference Cycles Munro and Sugden (2003) show that one can find three alternatives,

x, y and z such that

)()( yUzU yy

)()( zUxU zz

9

)()( xUyU xx

xyzx xyz

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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.

0)(20

)(020

)(8.0

8.0

aifaaifa

agaifaaifa

ag mx

*)(*)(),(*)*,( mmgxxgmxU mxmx

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€

U(0,0)(1,100) >U(0,0)(0,103)

Choose between “one mug and $100” and “no mug and $103” when there is no reference:

€

U(1,100)(1,100) <U(1,100)(0,103)

Now, status quo is “one mug and $100” what would you do?

STATUS QUO AVERSION !!!

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Constant Loss Aversion (CLA)

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We say Constant Loss Aversion if there is no diminishing sensitivity or constant sensitivity (gi is linear).

While Loss Aversion Model (i) permits non-convex indifference curves and intransitive preferences(ii) 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.

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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.

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Axiom of Status Quo Bias

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Movie

Sports

r1

r2 r

Acceptable alternatives

when r is status quo

Assume that r is the status quo

u2

u1

U = w1u1+w2u2

Masatlioglu and Ok, 2005 (The SQB Model)

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Loss Aversion vs. Status Quo Bias

Loss Aversion Model

Status Quo Bias Model

)(xrU

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Q(r)Bxmax

)(xU

Bxmax

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The Generalized SQB ModelMasatlioglu and Ok (2009)

)()()()(

rUyUrQyrQr

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Q(r)xmaxS

)(xU

such that Mental Constraint

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The Procedural RD Model Masatlioglu and Ok (2007)

)()()( rQyQrQy iii

)()()()(

rUyUrQyrQr

i

i

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otherwiseSS

(r)2Qx(r)1Q{r} if(r)1Qx

max

)(xU

such that

Another generalization of SQB model with two mental constraints, Q1and Q2

Some Facts about Experiment

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Conducted at C.E.S.S. (NYU) A total of 99 subjects Money and Chocolate Each subject answered 16 questionsOn average, earned $14 including the $7 show-up

fee and also some chocolates

Experimental Design

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r1

r5 r2r3r7

r6 r4

y

x

r0 Money

Bel

gium

Cho

cola

te

A Screen Shot from the Experiment

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Experimental Design: Theoretical Predictions

r1 r2

Classical Choice Theory

y y Yes

y x No

x x No

x y No

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r1

r2

y

x

r0 Good 1

Goo

d 2

There are four possible cases:

Assume that y is preferred to x when there is no reference point.

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Loss Aversion Model

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x

r2

y

r1

LA model favors x

Good 1

Good 2

r1 r2 LA CLA

y y Yes Yes

y x Yes Nox x Yes Yesx y No No

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SQB ModelAcceptable Alternatives Choice

r1 r1 x x

r2 r2 x y y

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r1

x

y

r2

SQB model favors y

u2

u1

u2

u1

r1 r2 SQB

y y Yes

y x Nox x Yesx y Yes

Good 1

Good 2

Generalized SQB Model

r1 r2 SQB GSQB

y y Yes Yes

y x No Yesx x Yes Yesx y Yes Yes

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Q(r1)

r2 Q(r2)

r1

x

y Q(r) ∩ B Choice

r1 r1 x y y

r2 r2 x x

GSQB model is indecisive

Good 1

Good 2

Procedural R-D ModelElimination

ChoiceQ1(r) ∩ B Q2(r) ∩ B

r1 r1 r1 x y y

r2 r2 x - x

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x

Q1(r1)

Q2(r1)

r2

y

Q1(r2)

Q2(r2)

r1

PRD model is also indecisive

r1 r2 SQB PRD

y y Yes Yes

y x No Yesx x Yes Yesx y Yes Yes

Good 1

Good 2

Theoretical Predictions for r1 r2

Tversky - Kahneman Masatlioglu - Ok

CLA LA SQB GSQB PRD

r1→ r2 - Favors x Favors y Indecisive Indecisive

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r1

r2

y

x

r0 Money

Belgium Chocolate

Theoretical Predictions

Tversky - Kahneman Masatlioglu - Ok

CLA LA SQB GSQB PRD

Group 1

r0→ r5 - I - - I

r0→ r6 - I - - I

r0→ r7 - I - - I

Group 2

r1→ r2 - x y I I

r3→ r4 - x y I y

r5→ r6 - x - - I

r5→ r7 - y - - I

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r1

r5 r2r3r7

r6 r4

y

x

r0

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Reference Effect: Preference Reversals

No reversal 269 %73Reversal 97 %27# Obs 366

r1→ r2 r3→ r4 r5→ r6 r5→ r7

r1 r2 r3 r4 r5 r6 r5 r6

No reversal 40 33 42 40 32 30 25 27Reversal 14 21 14 16 5 7 11 9# subjects 54 56 37 36

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Comparison of the Models

Tversky - Kahneman Masatlioglu - Ok Classical TheoryCLA LA SQB GSQB PRD

Total 65 89 68 75 93 48

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Explanatory Power of the Models (in percentages)

Selten’s Measure of Predictive Success

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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.

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THANK YOU

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A Sample Question from the Experiment

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Is SQB Axiom too strong?

)},,({)},,({yzyczxyxcy

)},,({ xzxcz

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Take x = CUNY, y = OSU and z = UM

OSU = c({CUNY, OSU},CUNY)

UM = c({OSU, UM},OSU)

But CUNY = c({CUNY, UM},CUNY)

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Relaxing SQB Axiom?

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Weak Status Quo Bias

andimplies

implies

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