Reference-Dependent Reservation Utility and the Comparison Discount

Abstract

This paper investigates how a risk averse and loss averse agent having reference-dependent reservation utility, affects the cost to the principal when the agent also has reference-dependent preferences. The main finding is that, under these circumstances, if the agent compares his outside alternative to the principal's offer, the principal pays less – a comparison discount – relative to the cost when reservation utility is not reference-dependent.

Keywords: principal-agent, reservation utility, reference-dependent preferences, comparison effect, contrast principle

JEL Classification: D82, D84, M12, M52