the causes of preference reversal observed preference reversal cannot be adequately explained by violations of independence the reduction axiom or transitivity the primary cause of preference reversal is the failure of procedure invariance especially the overpricing of low probability high payoff bets this result violates regret theory and generalized nonindependent utility models preference reversal and a new reversal involving time preferences are explained by scale compatibility which implies that payoffs are weighted more heavily in pricing than in choice copyright 1990 by american economic association

reference dependent ambiguity abstract motivated by experimental and empirical evidence i study a framework where reference points such as a status quo endowment or default option can distort the way an individual responds to ambiguity i characterize a model of reference dependent maxmin expected utility and provide behavioral foundations for comparing reference dependent ambiguity attitudes i also illustrate some implications of reference dependent ambiguity for trade in an asset market including underdiversification no trade and the potential for a market collapse

experience based dynamic choice a revealed preference approach abstract we use the revealed preference method to derive a model of dynamic choice where the agent s past experience may influence her current decisions our model generalizes the classical individual choice model which is rationalized by utility maximization and reduces to that model in the absence of experience as the agent gains experience her utility changes but only in a very restricted fashion every period after an alternative is chosen the utility of that and only that alternative may change while the utility of all other alternatives remains fixed the model provides a platform on which many behavioral dynamic phenomena may be examined we utilize it and look into the behavioral implications of bounded memory status quo bias and variety seeking

consequences of debt forgiveness strategic default contagion and lender learning i use a unique data set of loans to small business owners to examine whether lenders face adverse consequences when they grant debt forgiveness to borrowers i provide evidence consistent with borrowers communicating their debt forgiveness to other borrowers who then more frequently strategically default on their own obligations this strategic default contagion is economically large when the lender doubles debt forgiveness the default rate increases by 10 9 on average using an exogenous shock to the lender s forgiveness policy my findings suggest that as the lender learns about the extent of borrower communication the lender tightens its debt forgiveness policy to mitigate default contagion

does the preference reversal phenomenon necessarily contradict the independence axiom one of the most puzzling paradoxes in decision theory is the preference reversal phenomenon this phenomenon seems to contradict the transitivity axiom for a long time one of the cornerstones of utility theory this paradox is established whenever a decision maker prefers lottery x to lottery y but is willing to put a lower selling price on x than on y such experiments first reported by harold lindman 1971 and sarah lichtenstein and paul slovic 1971 were repeated by david grether and charles plott 1979 werner pommerehne et al 1982 and robert reilly 1982 although the later researchers improved the mechanism through which the selling price emerges they all found systematic reversals a new approach to this problem was developed by charles holt 1986 and edi karni and zvi safra 1987 from two different starting points these authors showed that the preference reversal phenomenon does not necessarily prove a violation of the transitivity axiom as it may contradict the independence axiom this implies that people do not maximize expected utility but in that case the preference reversal phenomenon becomes just another evidence against expected utility theory but not against the transitivity axiom these results have their own disadvantages although the independence axiom is not as fundamental as transitivity it is nevertheless very appealing on normative grounds of course the preference reversal phenomenon necessarily contradicts at least one of the assumptions of expected utility theory but empirical evidence shows that despite its normative appeal violations of the reduction of compound lotteries axiom may happen see for example joshua ronen 1971 and doug snowball and clif brown 1979 in this paper i therefore suggest a decision mechanism for the preference reversals lotteries which is transitive and satisfies the independence axiom but not the reduction axiom

the compromise effect in action lessons from a restaurant s menu the compromise effect refers to individuals tendency to choose intermediate options its existence has been demonstrated in a large number of hypothetical choice experiments this paper uses field data from a specialties restaurant to investigate the existence and strength of the compromise effect in a natural environment despite the presence of many factors that potentially weaken the compromise effect e g a very large choice set the opportunity to choose familiar options we find evidence for it both in descriptive statistics and regression analyses options which become a compromise after a change in the choice set gain on average five percent in market share we also find that the compromise effect is especially pronounced in groups while for single customers it is statistically insignificant

preference reversals and the independence axiom of all of the paradoxical patterns of behavior reported in laboratory experiments one of the most perplexing for decision theorists is the preference reversal phenomenon a subject in a preference reversal experiment is typically given a choice between a lottery with a high probability of winning a modest amount of money a p bet and a lottery with a low probability of winning a large amount of money a bet the lowest amount of money for which the subject would willingly sell either of these lotteries is also elicited the most common reversal is for a subject to choose the p bet over the bet but to put a higher selling price on the bet preference reversals were first reported by harold lindman 1971 and sarah lichtenstein and paul slovic 1971 in discussing the psychologists discovery of such reversals david grether and charles plott remark the inconsistency is deeper than mere lack of transitivity or even stochastic transitivity it suggests that no optimization principles of any sort lie behind even the simplest of human choices 1979 p 623 this paper offers a simple alternative explanation of documented preference reversals an explanation that does not require the abandonment of the transitivity assumption

financial risk perception are individuals variance averse or loss averse abstract finance theory tends to see risk as related to variance in expected returns whereas the psychology literature tends to link risk to probability or size of potential losses this paper investigates whether individuals perceptions of risk are linked to variance aversion or loss aversion and finds that a link to loss aversion is supported

choice by sequential procedures article history we propose a rule of decision making the sequential procedure guided by routes and show that three influential boundedly rational choice models can be equivalently understood as special cases of this rule in addition the sequential procedure guided by routes is instrumental in showing that the three models are intimately related we show that choice with a status quo bias is a refinement of rationalizability by game trees which in turn is also a refinement of sequential rationalizability thus we provide a sharp taxonomy of these choice models and show that they all can be understood as choice by sequential procedures

lagged beliefs and reference dependent utility abstract models of expectation based reference dependent preferences proposes that the reference point to which consumption outcomes are compared is endogenously determined as a function of lagged probabilistic beliefs this paper presents an experiment designed to test some predictions of expectation based reference dependence models the design induces a stochastic reference point via a lottery and then measures valuations for a commodity the experimental results find no effect of the first stage lottery on commodity valuation

independence of irrelevant alternatives and revealed group preferences it is shown that a pareto optimal and continuous single valued choice function defined on the compact convex subsets of the positive orthant of the n dimensional euclidean space maximizes a real valued function if and only if it satisfies the independence of irrelevant alternatives condition if n 2 and the strong axiom of revealed preference otherwise the results can be applied to consumer demand theory to deal with nonlinear budget sets and to bargaining game theory to generalize the nash bargaining solution

is status quo bias consistent with downward sloping demand by now there is a large experimental literature showing some kind of status quo bias 1 if the subject is given a coffee mug candy bar and later given the possibility of trading it for a candy bar coffee mug of equal value the subject is likely to stick with the original allocation knetsch 1989 here we ask whether status quo bias can be made consistent with downward sloping demand curves this paper thus differs in intent from a large body of research that incorporates a different notion of status quo bias into a more general formulation of revealed preference e g masatlioglu and ok 2005 sagi 2006 such research demonstrates that there are different sets of primitives that lead to different axioms of revealed preference in this paper we do not care which set of primitives holds or whether such results can be incorporated into the neoclassical model of consumer behavior as munro and sugden 2003 have done 2 instead we undertake a strict behavioralist approach individuals display status quo bias and downward sloping demand curves whether such behavior can be derived from a consistent set of assumptions is irrelevant to our purpose indeed we do not require the existence of a preference relation that rationalizes choices at all all that is required is choice behavior what we want to find out is the implications of such observed behavior in particular we want to determine whether status quo bias and downward sloping demand curves are consistent with each other the short answer is yes but the consumer will display addictive behavior 3 the remainder of the paper will be devoted to demonstrating this result we will make the following set of assumptions ai there are two goods x candy and y wine which are continuously divisible a2 prices and incomes are exogenously determined that is the person has a budget line and budget set a3 the individual chooses a point on the budget line a4 strictly downward sloping demand if the person chooses x sub t y sub t for a given budget set b sub t and then the person is faced with a different budget set b sub t l that goes through x sub t y sub t but where the relative price of x has gone down up then x sub t 1 x sub t and y sub t 1 y sub t 4 i an intuitive example before proceeding with the formal exposition it is useful to consider the intuition behind the argument to make the logic as accessible as possible in the intuitive example i will assume that individuals have indifference curves and that these indifference curves are homothetic before the subjects come to the experiment they made choices based on their individual budget sets and preferences the budget sets of these various individuals have the same slope the market prices facing the individuals are the same but the richer individuals have budget sets that are farther out if individuals have status quo bias then each individual s choice is based on his her budget set and his her unique set of indifference curves which in turn are based on the reference point established by the individual s experiences and history while we can use any time period for the analysis let us suppose here that the time period of analysis is daily so that before and after the experiment individuals decide each day how much candy and wine to choose the experimenter divides the subjects into three groups in the first group the experimenter gives the subjects 10 and then each subject gets to choose either candy or wine or some combination in between knetsch actually did this with candy and coffee cups and found that the subjects split evenly between the two choices in the second group the subjects are given 10 worth of candy and then later are allowed to trade in some or all of the candy for the equivalent value of wine

indecisiveness undesirability and overload revealed through rational choice deferral three reasons why decision makers may defer choice are indecisiveness between various feasible options unattractiveness of these options and choice overload this paper provides a choice theoretic explanation for each of these phenomena by means of three deferral permitting models of decision making that are driven by preference incompleteness undesirability and complexity constraints respectively these models feature rational choice deferral in the sense that whenever the individual does not defer he chooses a most preferred feasible option as a result choices are always consistent with the weak axiom of revealed preference the three models suggest novel ways in which observable data can be used to recover preferences as well as their indecisiveness desirability and complexity components or thresholds several examples illustrate the relevance of these models in empirical and theoretical applications

debt relief and debtor outcomes measuring the effects of consumer bankruptcy protection consumer bankruptcy is one of the largest social insurance programs in the united states but little is known about its impact on debtors we use 500 000 bankruptcy filings matched to administrative tax and foreclosure data to estimate the impact of chapter 13 bankruptcy protection on subsequent outcomes exploiting the random assignment of bankruptcy filings to judges we find that chapter 13 protection increases annual earnings by 5 562 decreases five year mortality by 1 2 percentage points and decreases five year foreclosure rates by 19 1 percentage points these results come primarily from the deterioration of outcomes among dismissed filers not gains by granted filers jel d14 i12 j22 j31 k35

consumer rationality and the status quo received microeconomic theory presumes rational consumers maximize utility over all commodity bundles recent analysis however suggests that a consumer s status quo may limit economic rationality bias consumer decisions and induce serious errors in survey based valuations of public and private goods using regression and choice theoretic frameworks we investigate the existence of status quo effects in the consumer valuation of a particular unpriced product the reliability of residential electrical service such valuations have become important in electric utility resource planning and rate making we find substantial status quo effects which must be addressed in welfare comparisons regarding electric service reliability

securitization and distressed loan renegotiation evidence from the subprime mortgage crisis abstract we examine whether securitization impacts renegotiation decisions of loan servicers focusing on their decision to foreclose a delinquent loan conditional on a loan becoming seriously delinquent we find a significantly lower foreclosure rate associated with bank held loans when compared to similar securitized loans across various specifications and origination vintages the foreclosure rate of delinquent bank held loans is 3 to 7 lower in absolute terms 13 to 32 in relative terms there is a substantial heterogeneity in these effects with large effects among borrowers with better credit quality and small effects among lower quality borrowers a quasi experiment that exploits a plausibly exogenous variation in securitization status of a delinquent loan confirms these results

preference reversals without the independence axiom the preference reversal phenomenon was believed to be inconsistent with the transitivity axiom of decision theory however recent theoretical papers have demonstrated that the preference reversals that were observed in earlier experiments could be explained by subject violations of the independence axiom or the compound lottery axiom therefore those preference reversals are not known to be inconsistent with generalization of expected utility theory that replace the independence axiom the present paper reports the results of experiments in which a substantial proportion of subject responses violate the asymmetry axiom these results are inconsistent with expected utility theory and its generalizations copyright 1989 by american economic association

decision time consideration time and status quo bias economists increasingly appreciate the value of studying the time taken to make decisions in order to provide insights into decision makers choices this article shows that studying how time is allocated among individual options is also valuable in helping researchers to understand the impact default options have on decision makers attention allocation as approximated by how the time is allocated the study of this impact generates new insights into the well known choice phenomenon of status quo bias which typically refers to decision makers tendency to stick to a default option by designing a series of novel experiments i find that this bias arises even when the choice is among prizes of fixed monetary value expressed in arithmetic form i also find asymmetric attention i e more time devoted to default options and strikingly asymmetric choice errors specifically decision makers fail to select an alternative better than the default 28 of the time while they incorrectly select an alternative worse than the default only 11 of the time and provide evidence supporting a causal relationship between asymmetric attention and asymmetric errors jel d03 d12 d83

performance pricing in bank debt contracts abstract performance pricing links bank debt interest rate spreads to a borrower s performance via two options interest decreasing performance pricing reduces spreads if credit quality improves it is more common when prepayment is more likely or costly and when adverse selection costs are higher and is less common when multiple performance measures better predict credit quality interest increasing performance pricing increases spreads if credit quality deteriorates it is more common when lenders reduce interest rates to add this provision when downgrades are more likely and when moral hazard costs are higher we find lower spreads for contracts with interest increasing performance pricing

the determinants of attitudes towards strategic default on mortgages we use survey data to measure households propensity to default on mortgages even if they can afford to pay them strategic default when the value of the mortgage exceeds the value of the house the willingness to default increases in both the absolute and the relative size of the home equity shortfall our evidence suggests that this willingness is affected by both pecuniary and non pecuniary factors such as views about fairness and morality we also find that exposure to other people who strategically defaulted increases the propensity to default strategically because it conveys information about the probability of being sued

accounting information in financial contracting the incomplete contract theory perspective this paper reviews theoretical and empirical work on financial contracting that is relevant to accounting researchers its primary objective is to discuss how the use of accounting information in contracts enhances contracting efficiency and to suggest avenues for future research we argue that incomplete contract theory broadens our understanding of both the role accounting information plays in contracting and the mechanisms through which efficiency gains are achieved by discussing its rich theoretical implications we expect incomplete contract theory to prove useful in motivating future research and in offering directions to advance our knowledge of how accounting information affects contract efficiency

probabilistic dominance and status quo bias abstract decision makers have a strong tendency to retain the current state of affairs this well documented phenomenon is termed status quo bias we present the probabilistic dominance approach to status quo bias an alternative is considered acceptable to replace the status quo only if the chances of a subjectively severe loss relative to the status quo are not too high probabilistic dominance is applied and behaviorally characterized in a choice model that allows for a range of status quo biases general enough to accommodate unanimity but also standard expected utility maximization we present a comparative notion of revealing more bias towards the status quo and study its implications to the probabilistic dominance model of choice lastly the model is applied to the endowment effect phenomenon and to a problem of international portfolio choice when investors are home biased

opportunistic underinvestment in debt renegotiation and capital structure abstract this paper models debt renegotiation as a bargaining game between debtholders and shareholder oriented management in which management credibly threatens to run down firm assets to force concessions from the creditors creditors anticipate this opportunistic behavior by management creating an upper bound on debt capacity that is less than the value of the firm if an advantage to debt is introduced such as favorable tax treatment an interior optimal capital structure obtains even in the absence of realized bankruptcy costs our model also explains variations in debt equity ratios and the use of certain puzzling debt covenants

observing violations of transitivity by experimental methods the preference reversal phenomenon is usually interpreted as evidence of nontransitivity of preference but has also been explained as the result of the difference between individuals responses to choice and valuation problems the devices used by experimenters to elicit valuations and the random lottery selection incentive system this paper reports an experiment designed so that none of these factors could generate systematic nontransitivities yet systematic violations of transitivity were still found the pattern of violation was analogous with that found in previous preference reversal experiments and is consistent with regret theory copyright 1991 by the econometric society

rational choice with status quo bias abstract motivated by the empirical findings concerning the importance of one s current situation on her choice behavior the main objective of this paper is to propose a rational choice theory that allows for the presence of a status quo bias and that incorporates the standard choice theory as a special case we follow a revealed preference approach and obtain two nested models of rational choice that allow phenomena like the status quo bias and the endowment effect and that are applicable in any choice situation to which the standard static choice model applies

status quo bias multiple priors and uncertainty aversion motivated by the extensive evidence about the relevance of status quo bias both in experiments and in real markets we study this phenomenon from a decision theoretic prospective focusing on the case of preferences under uncertainty we develop an axiomatic framework that takes as a primitive the preferences of an agent for each possible status quo option and provide a characterization according to which the agent considers a full dimensional set of possible priors and abandons her status quo option only if she finds an alternative that returns a higher expected utility for each of these priors we then show that in this framework the very presence of a status quo induces the agent to be more uncertainty averse than she would be without a status quo option

indifference or indecisiveness choice theoretic foundations of incomplete preferences abstract a commonly held belief in economics is that an individual s preferences that are revealed by her choices must be complete this paper takes issue with this position by showing that one may be able to distinguish between indifference and indecisiveness of an agent upon observing her choice behavior we relax the standard weak axiom of revealed preferences warp and show that a potent theory of individual choice with and without risk can be founded on this weaker axiom when it is coupled with some other standard postulates the most notable features here are that an agent is allowed to be indifferent between certain alternatives and indecisive about others moreover an outside observer can identify which of these actually occur upon examining the observable choice behavior of the decision maker as an application we also show how our theory may be able to cope with the classical preference reversal phenomenon

choice and individual welfare we propose an abstract method of systematically assigning a rational ranking to non rationalizable choice data our main idea is that any method of ascribing welfare to an individual as a function of choice is subjective and depends on the economist undertaking the analysis we provide a simple example of the type of exercise we propose namely we define an individual welfare functional as a mapping from stochastic choice functions into weak orders a stochastic choice function or choice distribution gives the empirical frequency of choices for any possible opportunity set framing factors may also be incorporated into the model we require that for any two alternatives x and y if our individual welfare functional recommends x over y given two distinct choice distributions then it also recommends x over y for any mixture of the two choice distributions together with some mild technical requirements such an individual welfare functional must weight every opportunity set and assign a utility to each alternative x which is the sum across all opportunity sets of the weighted probability of x being chosen from the set it therefore requires us to have a prior view about how important or representative a choice of x at a given situation is

consideration sets and competitive marketing we present a model of competitive marketing based on the notion that consumers are boundedly rational and that firms use marketing tactics in an attempt to influence consumers decision process the standard model of consumer behaviour assumes that the consumer applies well defined preferences to a perfectly perceived set of available alternatives we retain the assumption that consumers have stable preferences but relax the assumption that they have a perfect perception of what is relevant for their consumption problem thus allowing firms to manipulate that perception our aim is to explore the market implications of this departure from the standard model especially for the way firms deploy marketing strategies in competitive environments the cornerstone of our model is the observation that in the modern marketplace consumers face an overwhelmingly large variety of products and therefore often use screening criteria deliberate as well as unconscious in order to reduce the number of relevant alternatives as a result consumers apply their preferences not to the set of objectively feasible alternatives but to a potentially smaller set which they construct at an earlier stage of the decision process borrowing a term from the marketing literature we refer to this set as the consideration set the basic idea underlying this term is that consumers may be unaware of some of the feasible products and even when they become aware of a new product they still need to be persuaded to consider it as a potential substitute to their currently consumed product

identification of endogenous social effects the reflection problem this paper examines the reflection problem that arises when a researcher observing the distribution of behaviour in a population tries to infer whether the average behaviour in some group influences the behaviour of the individuals that comprise the group it is found that inference is not possible unless the researcher has prior information specifying the compisition of reference groups if this information is available the prospects for inference depend critically on the population relationship between the variables defining reference groups and those directly affecting outcomes inference is difficult to implossible if these variables are functionally dependent or are statistically independent the prospects are better if the variables defining reference groups and those directly affecting outcomes are moderately related in the population

why don t lenders renegotiate more home mortgages redefaults self cures and securitization we document the fact that servicers have been reluctant to renegotiate mortgages since the foreclosure crisis started in 2007 having performed payment reducing modifications on only about 3 percent of seriously delinquent loans we show that this reluctance does not result from securitization servicers renegotiate similarly small fractions of loans that they hold in their portfolios our results are robust to different definitions of renegotiation including the one most likely to be affected by securitization and to different definitions of delinquency our results are strongest in subsamples in which unobserved heterogeneity between portfolio and securitized loans is likely to be small and for subprime loans we use a theoretical model to show that redefault risk the possibility that a borrower will still default despite costly renegotiation and self cure risk the possibility that a seriously delinquent borrower will become current without renegotiation make renegotiation unattractive to investors

indifference and incompleteness distinguished by rational trade abstract we use an agent s strict preferences to define indifference and incompleteness relations that identify the sequences of trades that are rational to undertake if an agent makes sequences of trades of options labeled indifferent the agent will never be led to an inferior outcome but trades of options where no preference judgments obtain can lead to diminished welfare for one shot choices in contrast there can be no behavioral distinction between indifference and incompleteness applications include an isomorphism for incomplete preferences that indicates when weak and strict preferences contain interchangeable information a characterization of the possibly incomplete preference relations consistent with a one shot choice function and an equivalent definition of incompleteness that relies on the philosophical theory of incommensurability

mortgage modification and strategic behavior evidence from a legal settlement with countrywide abstract we investigate whether homeowners respond strategically to news of mortgage modification programs we exploit plausibly exogenous variation in modification policy induced by settlement of us state government lawsuits against countrywide financial corporation which agreed to offer modifications to seriously delinquent borrowers using a difference in differences framework we find that countrywide s monthly delinquency rate increased more than 0 54 percentage points a 10 percent relative increase immediately after the settlement s announcement the estimated increase in default rates is largest among borrowers least likely to default otherwise these results suggest that strategic behavior should be an important consideration in designing mortgage modification programs jel d14 g21 k22 r31

a canonical model of choice with initial endowments we use the revealed preference method to derive a model of individual decision making when the endowment of an agent provides a reference point that may influence her choices this model generalizes the classical rational choice model which views choice as a consequence of utility maximization instead our model sees choice as arising from psychologically constrained utility maximization where the constraints are induced by one s initial endowment in particular this model produces status quo bias as a natural consequence but not necessarily the endowment effect a range of economic applications identify the predictive and explanatory strength of the model in particular we demonstrate that the status quo bias phenomenon reduces the size of the substitution effect in problems of consumption choice

default and renegotiation a dynamic model of debt we analyze the role of debt in persuading an entrepreneur to pay out cash e ows rather than to divertthem in the e rstpartof the paper we study the optimal debt contract specie cally the trade off between the size of the loan and the repayment under the assumption that some debt contract is optimal in the second part we consider a more general class of nondebt contracts and derive sufficient conditions for debt to be optimal among these