Suppose Theo has reference-dependent preferences not just over money and teddy bears, but over money, teddy bears, and blocks.

Suppose Theo has reference-dependent preferences not just over money and teddy bears, but over money, teddy bears, and blocks. Let his consumption in money, teddy bears, and blocks be c1, c2, and c3, respectively, and let his reference points in money, teddy bears, and blocks be r1, r2, and r3, respectively. Then, Theo’s utility is given by

v(c1 − r1) + v(4c2 − 4r2) + v(4c3 − 4r3),

where v(x) = x for x ≥ 0, and v(x) = 2x for x < 0. Normalize Theo’s initial amount of

money to zero, and suppose he starts off with zero teddy bears and zero blocks.

Question:

Theo arrives at the experiment, and it turns out that he receives an $8 show-up fee, which he does not incorporate into his reference point for money. Suppose Theo is given a teddy bear (and he does incorporate this into his reference point). Calculate his selling price by writing down his reference point; and solving for the price pS that makes him indifferent between keeping his teddy bear and receiving nothing and giving up his teddy bear and getting pS.