From Breezes, the employee newsletter of the Federal Reserve Bank of Boston
While common sense dictates that consumers get annoyed when prices increase, the science of economics – which assumes that all people act rationally – has traditionally struggled to explain how human emotion can influence an individual’s economic decisions.
“Economists don’t have a way of explaining ‘mad,’” says Chris Foote, acting director of the bank’s Research Center on Behavioral Economics and Decision-Making. “When prices go up, economists would say that the incentives have changed, and they consider how people think rationally about the price change. But overall, economists don’t have a way of understanding emotions in their work.”
This theme emerged repeatedly at the “Implications of Behavioral Economics for Economic Policy” conference, the first such gathering hosted by the Research Center on Behavioral Economics and Decision-Making. More than 80 economists – some from the Federal Reserve System, others from academia – gathered at the bank recently to discuss how behavioral economic models should inform economic policymaking and central banking.
“We’re excited about this area, and I think that the time was right for the Federal Reserve System to dip its collective toe into the pool of behavioral economics,” says Foote. “We’re happy to be a part of it.”
The first session of the 11/2-day conference focused on the aforementioned topic of consumer reaction to prices, and how those reactions affect companies’ price-setting policies. Harvard Business School Professor Julio Rotemberg, a visiting scholar at the bank, led the discussion of his paper, “Behavioral Aspects of Price Setting and Their Policy Implications,” which states, according to Foote, “that by better understanding customer anger and reactions to price changes, economists might help explain some of the pricing data that show that firms are reluctant to frequently change prices.”
Given the turmoil in the domestic housing market of late, the first day’s final session, “Behavioral Economics and the Housing Market,” proved to be timely. Christopher Mayer, a former Boston Fed economist who now teaches at Columbia University, “talked about whether or not recent changes in housing prices could be explained by a rational model,” notes Foote, “or if there was a need to bring in behavioral notions like people falling into bubble psychology to understand what’s going on.”
Another area that has long perplexed economists is that of the labor market, and this was the focus of the conference’s third session, “Fairness and the Labor Market.” According to one of the bank’s behavioral economists, Lorenz Goette, who co-authored a paper on the topic, economists – who have traditionally treated the labor market like most markets – are now beginning to realize that humanity’s inherent need to be treated fairly may play a role in the relative rigidity of labor prices.
“The Fed is interested in this because we want to understand how wages are set on the aggregate level,” says Foote. “Why do wages move so slowly? Why, when a recession occurs and people are unemployed, don’t wages go down and these unemployed people take jobs at slightly lower wages? It doesn’t happen that way, and it’s frustrating for economists to understand this process.”
Other intriguing sessions included a discussion about consumer rationality and an engaging debate about whether or not central banks should be concerned about “maximizing happiness” amongst the populace.
The conference concluded with a heavyweight panel discussion that focused on the role of behavioral economics in the recent past and in the future. Panelists included James Poterba, who heads MIT’s Economics Department; Janet Yellen, president of the Federal Reserve Bank of San Francisco; and Lawrence Summers, former secretary of the U.S. Treasury and former president of Harvard University.
“One of the virtues of having 12 regional Federal Reserve Banks has been that it has, over time, made it possible for some of the banks to develop distinctive perspectives in their research, and to become centers of thought of a particular kind,” Summers said during the panel discussion. “So I would humbly suggest that the Boston Fed has made an excellent start with this conference, and should continue to adopt this distinctive research thrust in behavioral economics.”