Reference Incomes, Loss Aversion, and Physician Behavior

Abstract

We examine the effects of reference income on the behavior of young male physicians. Using a unique panel of data, we relate physicians' reference and actual incomes to their subsequent income growth. Reference income has a strong positive effect on subsequent income for physicians who are below their reference points, but not for physicians who are at or above their reference points. Loss aversion, which posits a kink in utility at the reference point, explains this puzzling pattern. Physicians respond strongly to shortfalls from the reference point-they take unappealing actions to boost earnings-because the marginal utility of income is steep in that range. Competing prominent theories, tested here, fail to explain these relationships. © 2003 President and Fellows of Harvard College and the Massachusetts Institute of Technology.