A Reference Dependent Representation with Subjective Tastes

Experimental and empirical evidence documents instances where the presence of an inferior option in a menu increases the attractiveness of the better options from that menu and thus distorts the normative ranking across menus. We analyze the case when besides this so called context effects bias there is also a concern for flexibility in the spirit of the literature initiated by Kreps (1979) and Dekel, Lipman and Rustichini (2001). Since the context effects bias and the desire for flexibility both increase the inclination of a decision maker to choose larger menus, the analysis allows the disentangling of the effect of the behavioral bias from the effect of the rational desire from flexibility. We find a weak condition on the set of ex post preferences under which the two effects are identifiable. We show that our representation is essentially unique. From a pedagogical viewpoint, our paper provides a novel methodology of identifying probabilities on the state space of subjective uncertainty introduced by Dekel, Lipman and Rustichini (2001) when this state space is infinite. This method renders the infinite state space essentially finite with respect to a certain salient property.