A Reference-Dependent Representation with Subjective Tastes

Abstract:     
Experimental and empirical evidence documents instances where the presence of an inferior option in a menu increases the attractiveness of the better options from that menu and thus distorts the normative ranking across menus. We analyze the case when in addition to this so called context-effects bias there is also a concern for flexibility, in the spirit of the literature initiated by Kreps (1979) and Dekel, Lipman and Rustichini (2001). Since the context-effects bias and the desire for flexibility both increase the inclination of a decision maker to choose larger menus, our analysis allows the disentangling of the effect of the behavioral bias from the effect of the rational desire from flexibility. We find a weak condition on the set of ex post preferences under which the two effects are identifiable. We show that our representation is essentially unique. From a methodological viewpoint, our paper provides a novel technique of identifying probabilities on the state space of subjective uncertainty introduced by Dekel, Lipman and Rustichini (2001) when this state space is infinite. This method renders the infinite state space essentially finite with respect to a certain salient property.

Number of Pages in PDF File: 33

Keywords: Context Effects, Reference Point Bias, Subjective Uncertainty.

JEL Classification: D81

working papers series