Habit Formation and Risk Preference Dependence

Abstract

Reference dependent preferences have been applied in both risky and certainty settings, although little attention has been directed at the relationship between the reference points as well as the loss aversion functions for these models. This paper addresses this relationship for the special case where reference dependence corresponds to habit formation. Multiperiod Expected Utility habit or persistence models have spawned important contributions in asset pricing, life cycle consumption, business cycle analysis and monetary models. Inherence in these models are two very different forms of preference dependence on prior period consumption. First, there is the classic certainty persistence effect of today's consumption on tomorrow's marginal utility of certain consumption. Second, today's consumption also affects tomorrow's choices over distributions of uncertain consumption -- a form of risk preference dependence. These two different reference points are confounded in the conventional models which conceals the fact that they can affect asset demand and consumption behavior quite differently. This paper provides a natural generalization of the standard Expected Utility habit model that allows for a separation of certainty persistence and risk preference dependence.