DP16560 The Welfare Economics of Reference Dependence
Empirical evidence suggests individuals often evaluate options relative to a reference point, especially seeking to avoid losses. We analyze welfare under reference dependence. We describe how welfare effects of policies depend on normative judgments about whether reference dependence reflects a bias or normative preference. Lowering reference points generally improves welfare, absent countervailing externalities or biases. Conversely, welfare effects of price changes depend strongly on normative judgments. We apply our theory to reference dependence exhibited in German workers’ retirement decisions. Our results suggest positive welfare effects of increasing the Normal Retirement Age but ambiguous effects of financial incentives to postpone retirement.