People evaluate an economic outcome -- be that their level of income, the number of hours they work, a product they consume, or the payment they make for an item -- not only according to some absolute valuation attached to the outcome in question, but also relative to relevant "reference points" determined by their context of experience. An important property of these comparative evaluations is "loss aversion": losses relative to a reference point are more painful than equal-sized gains are pleasant.
While economists recognize the potential importance of relative evaluations in general and loss aversion in particular, there is very little theoretical work examining its implications for important economic decisions and markets. In this project, Botond Koszegi and Matthew Rabin will develop and apply general models of how individuals think about economic outcomes in relative terms. The project will provide a general theory that economists and other researchers can use as a tool to study the implications of relative evaluations. In addition, Koszegi and Rabin will apply their theory to understand behavior in a host of economic settings, thereby directly contributing to knowledge about phenomena as wide-ranging and socially important as the response of individuals and firms to risk, employment contracts, individuals'consumption choices over time, and bidding behavior in auctions. While the focus of the project is to promote the incorporation of a single important psychological phenomenon into economics, the framework can also help develop criteria for doing the same with other psychological phenomena, aiding dialogue between the two social sciences.
