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Topic2e

# Topic2e - Topic IIE A New Approach to Loss Aversion Koszegi...

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Topic IIE: A New Approach to Loss Aversion Koszegi & Rabin (2006) : They develop a new and improved theory of reference-dependent utility with loss aversion. Speci fi cally, 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

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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