The Silver Lining of Crises – A Loss Aversion Based Model of Reform

31 Pages Posted: 19 Apr 2021

See all articles by Marcus Roel

Marcus Roel

Business School, Beijing Normal University

Zhuoqiong Chen

Harbin Institute of Technology - Shenzhen Graduate School

Date Written: April 15, 2021

Abstract

We explore how and when crises can help firms, organizations, and societies undertake beneficial reforms. In our model, a loss averse decision maker decides whether she should undertake a new project (a reform), characterized by a sequence of cash-flows, or stick with the status quo. In normal times, the decision maker may not pursue a beneficial project, a project with a positive net-present-value, for she places a greater emphasis on losses than on (equal sized) gains. We show that a sufficiently bad crisis guarantees that she undertakes the most beneficial project and characterize when a crisis begets change. When choosing between a single project and the status quo, a crisis can only shape preferences for the better. When choosing among multiple projects, it may distort choices. However, the crisis will always push the decision maker towards implementing a project that is better than the status quo. Implications for economic reforms and policy changes
are discussed.

Keywords: Economic Crisis, Reform, Loss Aversion, Reference-dependent utility

JEL Classification: D03, D91, G01

Suggested Citation

Roel, Marcus and Chen, Zhuoqiong, The Silver Lining of Crises – A Loss Aversion Based Model of Reform (April 15, 2021). Available at SSRN: https://ssrn.com/abstract=3827274 or http://dx.doi.org/10.2139/ssrn.3827274

Marcus Roel

Business School, Beijing Normal University ( email )

19 Xinjiekou Outer St
Haidian District
Beijing, Guangdong 100875
China

Zhuoqiong Chen (Contact Author)

Harbin Institute of Technology - Shenzhen Graduate School ( email )

Room 301A, Building B, HITSZ campus
University Town of Shenzhen
Shenzhen, Guangdong 518055
China

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