The Welfare Economics of Reference Dependence

We analyze welfare under reference-dependent preferences. We decompose the first-order welfare effects of reference point and price changes into direct and behavioral effects. The sign of these effects depends on the form of reference-dependent payoffs; which effects are welfare relevant depends on whether reference dependence reflects a bias. We characterize corresponding social welfare effects in terms of estimable reduced-form parameters and normative judgments. We apply our framework to reference dependence in German workers’ retirement decisions. We find positive welfare effects of local increases in the normal retirement age (NRA) but ambiguous effects of financial incentives to postpone retirement. (JEL D91, H55, J26, J32)