Momentum Trading Through Reference Dependent Preferences
34 Pages Posted: 14 Sep 2006 Last revised: 4 May 2010
Date Written: March 3, 2010
The endowment effect is a well-known behavioral regularity in which a person values a good more when he is endowed with it. In their generalization of prospect theory to consumption bundles with multiple attributes, Tversky and Kahneman  imply the endowment effect as a consequence of loss aversion and diminishing sensitivity in gains. It has since frequently been presumed that this form of reference dependent preferences will inhibit trade. However, in this paper it is demonstrated that loss aversion and diminishing sensitivity in gains also imply a dynamic momentum trading effect that increases exchange, so the net effect of such preferences on trading volume is ambiguous. In fact, the momentum trading effect is shown to completely cancel out the endowment effect in an important class of examples.
Keywords: loss aversion, reference dependence, prospect theory, endowment effect, status quo bias, general equilibrium theory
JEL Classification: D11, D51
Suggested Citation: Suggested Citation