Title: A Fuzzy-Set Based Model of Reference Point Formation

Abstract: We develop a model of reference point formation, that builds on psychological insights from adaptation-level theory (Helson, 1964) and its application to the pursuit of happiness (Brickman and Campbell, 1971). The model assumes that reference points are determined by temporal, social and spatial comparisons, and accounts for the mediating roles of perceived recency and perceived similarity in their formation. Since recency and similarity are vague concepts, we chose to base our model on fuzzy-set theory (Zadeh, 1965). The model is then incorporated into the framework of Kőszegi and Rabin (2006), to yield a model of reference-dependent preferences. An application of the model to consumer quality upgrades reveals that contrary to the predictions of standard economic analysis, upgrades may take place at different time periods, even when incomes and prices remain constant. Moreover, loss-aversion, together with perceptions of recency and of similarity are important predictors of the timing of upgrades.