How Consumers and Workers React Emotionally to Changes in Prices and Wages

One of the most important themes cutting across the conference presentations involves the emotional reactions that people have to changes in wages and prices. In the standard economic model, prices and wages affect behavior by altering the feasible choice sets of consumers, workers, and firms. Thus, changes in prices and wages prompt cognitive reactions, as economic agents recalculate their optimal plans in light of new information. By contrast, behavioral economists argue that emotional reactions to wages and prices are also important. Consumers facing price hikes (especially after natural disasters) are often intensely angry if they think that firms are taking advantage of market conditions to “unfairly” boost their profits at the expense of the public. Similarly, workers facing wage cuts often get angry if they view the employment relationship as one where the parties should treat one another fairly. A firm that cuts wages just because it can (for example, during a recession) is not living up to its side of the fairness bargain. Moreover, behavioral researchers claim that firms try to avoid triggering the negative emotional reactions of workers and customers by keeping wages and prices rigid. In this way, potential emotional reactions underpin the sluggishness of wages and prices that central banks must account for when conducting monetary policy. Emotional reactions may also explain the high degree of public support for laws that economists find economically inefficient, such as those that prevent price gouging or that set minimum wages.

Most conference attendees agreed that emotional reactions to wages and prices are possible, but they differed on the quantitative importance of such reactions. In particular, there was extensive discussion about whether these emotional reactions are as important as the other frictions that are captured by standard models of labor and product markets. For example, the workhorse New Keynesian model from the contemporary macroeconomic literature contends that price rigidity stems from the administrative costs of changing prices. These costs encourage firms to change prices only at specific times, not continuously. The menu cost model of prices has been subjected to a battery of empirical tests using both aggregate and product-level data whether these tests indicate a first-order problem that can be addressed by introducing emotional reactions is an open question.

Empirical support for emotional reactions to wages has come mostly from laboratory and field experiments. “Workers” in lab experiments often exert more effort if “firms” pay them high wages, with similar results from the limited number of field experiments that have been conducted. When these experiments are set up as one-shot settings, a good explanation for the effort wage relationship is that the fairness preferences of workers are giving rise to a “gift exchange condition.”

Yet despite being designed as one-time events the experiments may not engender true one-shot behavior by participants—due to the simple fact that one-shot situations are rare in the real world. So even when the experimenters make it clear to participants that a particular game is truly a one-shot scenario, human brains may be hard-wired to react to all games as if these represent ongoing interactions. Since strategic motives for an effort-wage tradeoff are not applicable in one-shot games, the issue is of great concern for experiments designed to mimic the labor market, as real-world employment relationships usually last for more than one period. Behavioral economists counter that the repeated nature of the real-world labor market can amplify the effects of fairness preferences on labor-market outcomes. In any case, the idea that emotional reactions embedded in fairness preferences are truly needed to explain how the labor market functions is a fascinating hypothesis that may very well help us understand some fundamental labor-market facts. 

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