Reference Point

What is a reference point?

A reference point is a comparison level used to evaluate an outcome. In prospect theory, it separates outcomes treated as gains from those treated as losses. It may reflect the current situation, an expectation, or how the decision is presented.

Illustrative example

A payment of $120 is $20 above an expected payment of $100 and $30 below an expected payment of $150. The amount received is identical, but the comparison differs.

Reference points in prospect theory

Reference dependence concerns the role of this comparison. Loss aversion concerns greater weight on a loss than an equivalent gain. Diminishing sensitivity concerns smaller changes in subjective value for each additional unit farther from the reference point. They are additional properties of the value function; neither follows from having a reference point alone. Framing can also change which comparison a person uses.

What determines a reference point?

Current circumstances, previous experience, expectations, and comparisons with other people are possible benchmarks. They need not remain fixed. A raise can become the new normal against which the next offer is judged.

Limits

A useful analysis must identify the relevant benchmark rather than select one after seeing a choice. A comparison level does not by itself predict a person’s decision or establish that the decision is a mistake.