2010-2011 Essay Contest

Second Place Essay—Advanced Economics

Managing Reference Frames: Wage, Rigidity, Information, and a More Dynamic Labor Market


Thomas Bergen
The Blake School
Minneapolis, Minnesota

Daniel Kahneman and Amos Tversky in the conclusion of their paper, "Loss Aversion in Riskless Choices: A Reference-Dependent Model," hypothesized that consistent reference prices in the labor market could result in wage rigidity.1 Workers are captured in conscious reflection that inhibits them from participating in rational and efficient market interactions. An auction study performed at MIT manipulated subjects' receptiveness to higher prices by instituting the last two digits of their social security number as random reference prices.2 Before they bid, participants were asked if they were willing to pay that sum for the product. Then they were asked to make an offer. Subjects with the higher reference price, a.k.a. their social security number, bid "57% to 107% higher" than subjects with the lower reference frames.

According to classical economic theory, people should act rationally according to their personal marginal utility. This should have been reflected in the bids given by the subjects at MIT, but these theoretically meaningless anchor prices actually affected the choices of the participants in the study. The pattern depicted in the MIT study is echoed throughout countless other papers, suggesting that reference frames can similarly influence a wide variety of market interactions. With the recent job crisis, inflated reference frames and loss aversion result in downward wage rigidity that hampers the growth of the economy. Information provided by the government could generate realistic reference frames and promote a more dynamic labor market.

A loss or gain from a reference point is a more significant factor in determining utility than the wellbeing, happiness, or usefulness of that thing.3 An individual's loss is rooted in a specific reference frame; what can be considered a loss is relative and varies from person to person. The different reference points can change people's perception of their environment and utility, and, consequently, their behavior in the market.4 Loss aversion affects how people perceive a change from their reference point, commonly derived from their status quo, and they develop their utility from that change.5

Reference frames come into effect whenever anyone contemplates buying something.6 That reference price becomes the perceived status quo and subconsciously all other prices are compared to it.7 This affects how individuals view and negotiate their wages. Tversky and Kahneman postulated that rigid wages induced by set reference frames "result in inefficient labor contracts that fail to respond adequately to changing economic circumstances and technological development".8 Just like the participants in the auction study, workers form reference wages, which change their utility. They perceive their previous wage as an anchor price and measure relative gains and losses to it.9

With locked reference frames, workers tend to exhibit loss aversion when negotiating wages. With the recent recession, U.S. unemployment figures remain steadily above 9%.10 Downward wage rigidity produced by these long-term reference frames is one of the main causes of this stagnation. In a recent paper, Robert Shimmer presented some of the setbacks caused by wage rigidity pointing out, "if wages are rigid, there is a long-lasting (but not permanent) decline in employment, capital, output, consumption, and investment relative to trend."11 An article from The Wall Street Journal, suggested that without lower wages it would be hard to bounce back.12

Government intervention to reduce individuals' reference frames can be an effective way to carry out its expected role to "promote economic growth and stability".13 When wage rigidity riddles the labor market, government can play a role to fix the market failure. In order to influence labor market reference prices, the government can provide comprehensive information. For example, it could set up an online interactive reference source for accurate (or suggested) wages, which can change with input from national wages and economists. Market participants would be able to form reference prices around these more flexible wages. In order to further induce people to change their reference frames, the US government can utilize "social nudges".14 In a recent paper, Vladas Griskevicius and Mark Van Vugt explored ways to induce people to make greener choices. They suggested that by informing individuals of a large group activity they could influence people to act similarly.15 Simply informing people "about what other people are doing" provides social reference frames that change behavior.16 Government programs could present workers with relative information on wage movements and coax individuals out of their rigid reference frames.

It is unrealistic to expect any private institution to independently create this resource efficiently. To effectively develop flexible wages, the information must be widely accessible. The government is comparatively advantaged to provide this information to the public. By virtue of its position to gather data from a large pool of workers, it can compile a more accurate resource than a private firm. Furthermore, trust in the federal or state government could lend credibility to the program. In addition, Robert Frank argued that lowering societal reference frames causes beneficial externalities such as decreased absence from work, and improved happiness.17 Because of these beneficial externalities, the government, rather than private firms, could provide a more socially optimal amount of information.

Improved information throughout the economy could battle downward wage rigidity. Inflated reference wages are causing inefficient negotiation. People become trapped in a cage of conscious comparison. Reference frames inhibit the market from acting efficiently through downward wage rigidity. The government could institute programs, which could change society's reference prices and boost the U.S. job market. We must break from our "mind-forged manacles" that bind us and reclaim our right to truly free negotiation.18

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References

1/ Amos Tversky and Daniel Kahneman. "Loss Aversion in Riskless Choices: A Reference-Dependent Model," The Quarterly Journal of Economics 106, no. 4 (November 1991): http://www.jstor.org/stable/2937956 (accessed January 12, 2011).

2/ Dan Ariely, George Loewenstein, and Drazen Prelec, "Coherent Arbitrariness: Stable Demand Curves Without Stable Preferences," The Quarterly Journal of Economics 118, no. 1 (February 2003): p. 7, http://cepr.org.uk (accessed January 27, 2011).

3/ Daniel Kahneman, Jack L. Knetsch, and Richard H. Thaler, "Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias," The Journal of Economic Perspectives 5, no. 1 (Winter 1991): p. 199, http://links.jstor.org/sici?sici=0895-3309%28199124%295%3A1%3C193%3AATEELA%3E2.0.C0%3B2-V (accessed January 12, 2011).

4/ Matthew Rabin, "Psychology and Economics," Journal of Economic Literature 36, no. 1 (March 1998): p. 13, http://www.jstor.org/stable/256495 (accessed January 16, 2011).

5/ Daniel Kahneman and Amos Tversky, "Prospect Theory: An Analysis of Decision under Risk," Econometrica 47, no. 2 (March 1979): p. 286,http://links.jstor.org/sici?sici=0012-9682%28197903%2947%3A2%3C263%3APTAA0D%3E2.0.CO%3B2-3 (accessed January 12, 2011).

6/ Dan Ariely, Predicably Irrational (2008; repr., New York: HarperCollins, 2010), p. 30.

7/ Daniel Kahneman and Amos Tversky, "Prospect Theory: An Analysis of Decision under Risk," Econometrica 47, no. 2 (March 1979): p. 286,http://links.jstor.org/sici?sici=0012-9682%28197903%2947%3A2%3C263%3APTAA0D%3E2.0.CO%3B2-3 (accessed January 12, 2011).

8/ Amos Tversky and Daniel Kahneman, "Loss Aversion in Riskless Choices: A Reference-Dependent Model,"The Quarterly Journal of Economics 106, no. 4 (November 1991): p. 1057, http://www.jstor.org/stable/2937956 (accessed January 12, 2011).

9/ George A. Akerlof, "Behavioral Macroeconomics and Macroeconomic Behavior," The American Economic Review 92, no. 3 (June 2002): p. 420.

10/ Rebecca Thiess, "The Great Recession's Long Tail," Economic Policy Institute (February 2011): p. 2.

11/ Robert Shimer, "Wage Rigidities and Jobless Recoveries" (Federal Reserve Bank of Atlanta), http://www.frbatlanta.org/news/conferences/10CHCS_agenda.cfm (accessed January 12, 2011).

12/ Timothy Aeppel, "Sticky Wages Hold Back Job Growth," The Wall Street Journal, November 12, 2010, http://blogs.wsj.com/economics/2010/11/12/sticky-wages-hold-back-job-growth/?blog_id=8&post_id=12452 (accessed January 12, 2011).

13/ Charles L. Schultze, The Public Use of Private Interest (Washington D.C.: The Brookings Institution, 1977), p. vii.

14/ Richard H. Thaler and Cass R. Sunstein, Nudge (2008; repr., n.p.: Yale University Press, 2009), p. 53.

15/ Vladas Griskevicius and Mark Van Vugt, "Sustainability Marketing: Human Nature, Consumption, and Conservation" (working paper), http://www.rotman.utoronto.ca/userfiles/departments/obhr/Griskevicius_Sustainability_Marketing.doc.

16/ Richard H. Thaler and Cass R. Sunstein, Nudge (2008; repr., n.p.: Yale University Press, 2009), p. 66. (but in fact all of chapter 3 would support this idea.)

17/ Reobert H. Frank, "The Frames of Reference as a Public Good," The Economic Journal 107, no. 445 (November 1997): p.1832-1835, http://www.jstor.org/stable/2957912 (accessed January 27, 2011).

18/ William Blake, "London," Poetry Foundation, http://www.poetryfoundation.org/archive/poem.html?id=172929 (accessed January 27, 2011).

Bibliography

Ariely, Dan. Predicably Irrational. 2008. Reprint, New York: HarperCollins, 2010.

Thaler, Richard H., and Cass R. Sunstein. Nudge. 2008. N.p.: Reprint, Yale University Press, 2009.

Kahneman, Daniel, Jack L. Knetsch, and Richard H. Thaler. "Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias." The Journal of Economic Perspectives 5, no. 1 (Winter 1991): 193-206.
http://links.jstor.org/sici?sici=0895-3309%28199124%295%3A1%3C193%3AATEELA%3E2.0.C0%3B2-V (accessed January 12, 2011).

Tversky, Amos, and Daniel Kahneman. "Loss Aversion in Riskless Choices: A Reference-Dependent Model." The Quarterly Journal of Economics 106, no. 4 (November 1991): 1039-1061. http://www.jstor.org/stable/2937956 (accessed January 12, 2011).

Kahneman, Daniel, and Amos Tversky. "Prospect Theory: An Analysis of Decision under Risk." Econometrica 47, no. 2 (March 1979): 263-292. http://links.jstor.org/sici?sici=0012-9682%28197903%2947%3A2%3C263%3APTAA0D%3E2.0.CO%3B2-3 (accessed January 12, 2011).

Shimer, Robert. "Wage Rigidities and Jobless Recoveries." Federal Reserve Bank of Atlanta. http://www.frbatlanta.org/news/conferences/10CHCS_agenda.cfm (accessed January 12, 2011).

Aeppel, Timothy. "Sticky Wages Hold Back Job Growth." The Wall Street Journal, November 12, 2010. http://blogs.wsj.com/economics/2010/11/12/sticky-wages-hold-back-job-growth/?blog_id=8&post_id=12452 (accessed January 12, 2011).

"An Illustration of a Value Function." Chart. In Loss Aversion in Riskless Choices: A Reference-Dependent Model, by Amos Tversky and Daniel Kahneman, 1040. MIT Press, 1991. http://www.jstor.org/stable/2937956 (accessed January 12, 2011).

behaviouralfinance.net. http://prospect-theory.behaviouralfinance.net/ (accessed January 12, 2011).

Goette, Lorenz, David Huffman, and Ernst Fehr. "Loss Aversion and Labour Supply." Journal of the European Economic Association 2, no. 2/3 (April-May 2004): 216-228. http://www.jstor.org/stable/40004898 . (accessed January 12, 2011).

Rabin, Matthew. "Psychology and Economics." Journal of Economic Literature 36, no. 1 (March 1998): 11-46. http://www.jstor.org/stable/2564950 (accessed January 16, 2011).

David Broncaccio. Marketplace. APM. January 21, 2011. itunes. http://itunes.apple.com/podcast/apm-marketplace/id201853034 (accessed January 22, 2011).

Card, David. "Interview with David Card." Interview by Douglas Clement. December 2006. Minneapolis Federal Reserve.
http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=3190 (accessed January 22, 2011).

Howden, David. "The Greek Plague: Sticky Wages." Ludwig Von Mises Institute, June 24, 2010. http://mises.org/articles.aspx?authorId=1259 (accessed January 24, 2011).

Samuelson, William, and Richard Zeckhauser. "Status Quo Bias in Decision Making." Journal of Risk and Uncertainty (1988): 7-59.

Ariely, Dan, George Loewenstein, and Drazen Prelec. "'Coherent Arbitrariness': Stable Demand Curves Without Stable Prefferences." The Quarterly Journal of Economics 118, no. 1 (February 2003): 73-105. http://cepr.org.uk (accessed January 27, 2011).

Frank, Reobert H. "The Frames of Reference as a Public Good." The Economic Journal 107, no. 445 (November 1997): 1832-1847. http://www.jstor.org/stable/2957912 (accessed January 27, 2011).

Thiess, Rebecca. "The Great Recession's Long Tail." Economic Policy Institute (February 2011): 1-10.

Schultze, Charles L. The Public Use of Private Interest. Washington D.C.: The Brookings Institution, 1977.

Griskevicius, Vladas, and Mark Van Vugt. "Sustainability Marketing: Human Nature, Consumption, and Conservation." research paper. http://www.rotman.utoronto.ca/userfiles/departments/obhr/Griskevicius_Sustainability_Marketing.doc.

Dickenson, Emily. "No Rack Can Torture Me." American Poems. http://www.americanpoems.com/poets/emilydickinson/10336 (accessed January 27, 2011).
I was planning to use part of this poem as an epigraph to my essay, but sadly I did not have enough room in my paper for it. So I decided to put it in my bibliography:

"Except Thyself may be
Thine Enemy
Captivity is Consciousness
So's Liberty."
-Emily Dickenson

Akerlof, George A. "Behavioral Macroeconomics and Macroeconomic Behavior." The American Economic Review 92, no. 3 (June 2002): 411-433.

Baumal, William J., and Alan S. Blinder. Economics: Prinicples and Policy. 10th ed. Edited by Jack W. Calhoun. Thomson South-Western, 2007. CourseSmart Bookshelf e-book.

Blake, William. "London." Poetry Foundation. http://www.poetryfoundation.org/archive/poem.html?id=172929 (accessed January 27, 2011).

 

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