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Reference Dependence and Labor-Market Fluctuations

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Understanding the economics of cognitive frictions

EU-funded researchers are building on existing economic models to better understand how macroeconomic fluctuations affect both the labour market and consumer behaviour.

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In a recession, characterised by fewer jobs and more jobseekers, the rules of supply and demand say wages should fall. However, historically, this has not been the case. One common explanation for this, as the Morale Hazard Theory, is that the labour contract’s inherent incompleteness forces employers to rely on workers’ intrinsic motivation. When workers feel they are being treated unfairly, their intrinsic motivation decreases – as does their output. A new approach to an old theory To better understand the theory’s applicability to current market trends, the EU-funded RDLMF project is taking a page from behavioural economics. The project proposes a theoretical framework that integrates three leading economic frameworks: macroeconomic models of search and matching; behavioural models of social preferences; and behavioural models of time inconsistent, reference-dependent preference. ‘Instead of conducting a traditional macroeconomic competitive equilibrium analysis, we follow the modern approach of non-cooperative game theory,’ says researcher Kfir Eliaz. This approach has led to several new conclusions. First, following a layoff, workers experience downward wage rigidity and a decrease in output. Second, newly hired workers earn relatively flexible wages, but not as much as in the benchmark without reference dependence (benchmark is a model for search and matching, whereas reference dependent preferences are those where an individual evaluates an outcome as either a gain or a loss relative to a reference point). Third, market tightness is more volatile than under the benchmark. ‘This framework helps us explain large fluctuations in unemployment alongside downward rigidity in wages,’ says Eliaz. Applicability to other markets RDLMF has gone well beyond reference-dependence and the labour market, using the same approach to also explore behavioural frictions in other markets. ‘We propose a new game-theoretic framework for analysing how firms interact with consumers who purchase multiple types of goods, but are able to examine only a limited number of markets for the best price,’ says Eliaz. What researchers found is that consumers focus their limited attention on their highest expenses. Therefore, a firm’s price can either draw or deflect attention by either being among the most expensive or cheapest. ‘Consequently, limited attention introduces a new dimension of cross-market competition, which leads to the surprising finding that increasing consumer attention can actually reduce consumer welfare,’ explains Eliaz. ‘Although consumers are more likely to miss the best offers, enhanced cross-market competition decreases average prices, meaning firms will try to stay under a consumer’s radar.’ A common thread The common thread between this consumer research and the research on the Morale Hazard Theory is how market frictions stem from cognitive sources. As Eliaz explains, reference-dependence stems from our tendency to evaluate changes, not consequences, from a reference point. ‘One cognitive friction that is prevalent in today’s information-rich consumer market is limited attention,’ he says. ‘The question is, does this lead to an effect similar to the one in labour markets – large fluctuations in prices that increase as the bias of consumers with limited attention spans become more severe?’ The general conclusion is that in order to understand important market phenomena like this, one has to widen the view of what governs individual behaviour. ‘In other words, standard, knee-jerk policy interventions such as encouraging more competition do not necessarily improve welfare,’ concludes Eliaz.


RDLMF, economics, macroeconomics, consumer behaviour, Morale Hazard Theory, recession, labour

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