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

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