A Contest Model With Reference-Dependent Preferences

Abstract

This paper introduces a two-stage winner-take-all contest model with reference-dependent preferences to study the determinants of conflict and its intensity. The existence of a Sub-game Perfect Nash equilibrium in pure strategies and characterization of the equilibrium are shown. Reference points are crucial in the decision of waging war and imply conflicts of higher intensity compared to standard models. The model delivers predictions in line with existing evidence and explains common empirical patterns in the conflict literature that previous models cannot account for. First, conflict is more likely to occur after negative income shocks since agents' current situation is perceived as a loss compared to the status quo. Second, income reduces the odds of conflict if agents are more risk-averse for gains than risk-seeker for losses.

Keywords: contests, reference point, loss aversion, conflict, war, income

JEL Classification: C72, D03, D74, D81