Expectation-Based Loss Aversion and Strategic Interaction

Abstract

Extending the equilibrium concepts of Kőszegi and Rabin (2006, 2007), this paper analyzes the strategic interaction of expectation-based loss-averse players. For loss-averse players with choice-acclimating expectations the utility from playing a mixed strategy is not linear but convex in the probabilities they assign to their pure strategies. As a consequence, they are generally unwilling to randomize and an equilibrium may fail to exist. For players with choice-unacclimating expectations, in contrast, randomizing over their pure strategies may indeed constitute a credible best response and an equilibrium always exist. Building upon these insights, we delineate how expectation-based loss-averse players differ in their strategic behavior from their counterparts with standard expected-utility preferences, derive novel strategic effects, discuss equilibrium selection, and derive equilibrium play for some simple games.