The Strategic Logic of Reference Dependence in Risk Taking

We show how individual strategies in market entry games depend on randomly induced prior outcomes and on the competitors’ beliefs about reference dependence in risk taking. On average, competitors take greater risk the lower their own outcome is and the greater the outcomes among their competitors are. This risk pattern is consistent with the belief among the majority of players who believe that lower outcomes lead to greater risk taking. The pattern reverses for players who believe that higher outcomes lead to greater risk taking. A player’s belief about the reference dependence of his competitors’ strategies shapes the reference dependence of his own strategies. Our findings support that players i.) ascribe information value about strategic risk propensities to prior outcomes, ii.) hold widely varying beliefs about the nature of reference dependence, iii.) project that their competitors hold beliefs about reference dependence that are similar to theirs, and iv.) adjust their strategies in ways that are consistent with their belief about reference dependence. Thus, reference dependence in strategic risk taking follows, at least partially, a conscious strategic logic. This logic can induce ecological rationality. More homogenous beliefs among the competitors about the nature of reference dependence result in substantially better coordinated markets.