Topic2e - Topic IIE: A New Approach to Loss Aversion...

Info iconThis preview shows pages 1–4. Sign up to view the full content.

View Full Document Right Arrow Icon
Topic IIE: A New Approach to Loss Aversion : They develop a new and improved theory of reference-dependent utility with loss aversion. Specifically, they address two major issues — two “loopholes” in the existing approach: (1) What determines the reference point? (2) When do people experience loss aversion, and what is the magnitude of this experience? They address these issues by incorporating two novel features: (1) A person’s reference point is her recent beliefs or expectations about outcomes. (2) Gain-loss utility is directly tied to the intrinsic utility from consumption — so that a person experiences more gain-loss utility for goods that involve more consumption utility. 1
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Model : Suppose there are N goods: Person chooses a vector ( x 1 ,x 2 ,...,x N ) . Reference point is a vector ( r 1 ,r 2 ,...,r N ) . Preferences are: Total Utility N X i =1 [ w i ( x i )+ v i ( x i | r i )] . w i ( x i ) is intrinsic utility for good i . v i ( x i | r i ) is gain-loss utility for good i . How to formalize that gain-loss utility is directly tied to intrinsic utility: Assume there exists a “universal gain-loss function” μ ( z ) such that for each good i , gain-loss utility is v i ( x i | r i )= μ ( w i ( x i ) w i ( r i )) . In general, μ ( z ) takes form of the Kahneman-Tversky value function. We’ll focus on the special case: μ ( z )= ( η z if z 0 ηλ z if z 0 2
Background image of page 2
c )andmoney( m ), with intrinsic utilities: w c ( c ) θ c w m ( m ) m Recall: Gain-loss utility is v i ( x i | r i )= μ ( w i ( x i ) w i ( r i )) , where μ ( z )= ( η z if z 0 ηλ z if z 0 Suppose you start with 0 shoes and wealth w ,andyou have the option to purchase a pair of shoes for price p . Let’s analyze behavior as a function of expectations: Case 1: Suppose you expect to buy a pair of shoes = reference point is ( c =1 ,m = w p ) : Buy when p 1+ ηλ 1+ η θ . Case 2: Suppose you expect not to buy any shoes
Background image of page 3

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Image of page 4
This is the end of the preview. Sign up to access the rest of the document.

This note was uploaded on 04/01/2009 for the course ECON 3240 taught by Professor Lyons during the Spring '09 term at Cornell University (Engineering School).

Page1 / 13

Topic2e - Topic IIE: A New Approach to Loss Aversion...

This preview shows document pages 1 - 4. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online