Reference-Dependent Consumption Plans

We develop a dynamic model in which utility depends on consumption as well as recent changes in beliefs about present and future consumption, and bad news is more painful than good news is pleasant. We assume a person’s beliefs must be rational in that she must find her own plan for statecontingent behavior credible: given the expectations generated by the plan, in each period it maximizes discounted expected utility taking into account that continuation plans must also be consistent with rationality. Applying our model to the acquisition of decision-irrelevant information, we show that to avoid fluctuations in beliefs, a person prefers to receive information clumped together rather than separately. Our theory also predicts reference-dependent attitudes toward current changes in wealth—even if wealth is exclusively for future consumption and there is substantial uncertainty about future income—because such changes constitute news about the distribution of future consumption. We also apply our theory to a twoperiod consumption-savings problem, where many of our results follow from the assumption that surprises in imminent consumption resonate more than surprises in future consumption. Since raising current consumption above the planned level is a pleasant surprise, a decisionmaker might overconsume early relative to the optimal committed plan. While the aversion to losses from lowering planned future consumption can deter overconsumption when plans are deterministic, uncertain plans mitigate this countervailing force, so overconsumption is exacerbated by current uncertainty. Because a surprise increase in lifetime wealth is most pleasant, and a surprise decrease most unpleasant, if consumed immediately, a person responds asymmetrically to surprises. And since higher consumption reduces the sensation of loss from lower-than-expected consumption whenever the consumption utility function is concave, our model unambiguously predicts firstorder precautionary savings in response to anticipated uncertainty about future income. JEL code: D81 Email: botond@econ.berkeley.edu, rabin@econ.berkeley.edu. Mailing Address: University of California, Berkeley, Department of Economics, 508-1 Evans Hall #3880, Berkeley, CA 94720. This paper updates and replaces earlier versions titled “Dynamic Reference-Dependent Preferences,” first presented and posted in June, 2006. We are grateful to Avinash Dixit and Neel Mukherjee, and seminar audiences at the Conference in Honor of Eytan Sheshinski, University of California, Berkeley, CERGE-EI, University of Chicago, Cornell University, University of Edinburgh, Harvard University, London School of Economics, University of Michigan, Princeton University, University of California, San Diego, University of Southern California, and University of Texas, Austin, and especially three anonymous referees for useful comments. We thank the National Science Foundation (Grant Award #SES-0648659) for financial support. Kristóf Madarász provided research assistance. In this paper, we develop a general dynamic model of reference-dependent utility. Building on ideas and models in Matthey (2005), Hsee and Tsai (2006), Kimball and Willis (2006), and Kőszegi and Rabin (2006, 2007), we assume that utility depends on recent changes in rational beliefs about present and future consumption, and bad news is more painful than good news is pleasant.1 We derive implications of our model for preferences over receiving information about an exogenous future event, monetary risk preferences, and intertemporal consumption decisions. If news about more imminent consumption is felt more heavily than news about distant consumption, a person prefers to receive the same information sooner rather than later, increases consumption immediately in response to good surprises regarding wealth but delays cuts following bad surprises, and—since surprising herself with extra immediate consumption is pleasant—may overconsume early in life relative to the optimal committed plan. To reduce the impact of losses she may suffer, the decisionmaker prefers to receive bits of information together rather than apart, and—to lower the marginal utility associated with any surprise losses—prepares for future uncertainty by increasing savings. We present the basic framework in Section 2. In each period t ∈ {1, . . . , T}, the decisionmaker consumes a K-dimensional consumption bundle, ct. Overall instantaneous utility in period t is the sum of reference-independent “consumption utility” that derives purely from ct, and gainloss utility that derives from recent changes in beliefs about consumption in each dimension in each period starting with t. The person experiences “contemporaneous” gain-loss utility from any contrast between current consumption and her prior expectations of current consumption, and “prospective” gain-loss utility from changes in her beliefs about future consumption. In all these comparisons, she is loss averse: bad news about consumption is more unpleasant than good news is pleasant. Normalizing the weight γt,t on contemporaneous gain-loss utility to 1, in period t the decisionmaker puts weight γt,τ ≤ 1 on prospective gain-loss utility regarding outcomes in period τ > t. Her goal in period t is to maximize the sum of instantaneous utilities starting in period t. Because preferences depend on the sequence of expectations, our model is complete only when 1 The model in this paper is closely related to contemporaneous work by Matthey (2006). Building on her earlier intuitions in Matthey (2005), she develops a formal model of preferences that is similar to our formulation. But her solution concepts embed different assumptions than ours about how people form their beliefs, and she develops a different set of results.