« Stabilizing Credit Markets: The TSLF and Other Asset Composition Policies | Main | Alan Greenspan: Models of Risk »

Sunday, March 16, 2008

Arbitrary Coherence

How do we decide if something is worth purchasing?:

Shhh . . . Don't Say 'Recession,' by Dan Ariely, Commentary, Washington Post: ...[Could] current talk about a recession ... actually be creating one? Well, maybe. Or so one general finding of behavioral economics would have us believe.

With all this chatter about a recession, consumers might, for example, hold off on buying that new dishwasher because of the "bad economy," or pass up the more expensive restaurant because "we're in a recession."...

Consider the experience of eating a Godiva truffle... Now think about ... how much it's worth to you. A quarter? 50¢? 75¢? $1.25? $2.50? While the experience of eating a truffle is very familiar, figuring out what we would be willing to pay for it proves difficult. So what do we do when we make purchasing decisions? Generally, we use past decisions as a guiding principle. If we have paid 50¢ for a Godiva truffle in the past, we remember this decision, assume it was a good one and probably repeat it again and again. ...

What ...[does this show]? The existence of what we called arbitrary coherence. The basic idea of arbitrary coherence is this: Although initial prices can be "arbitrary," once those prices are established in our minds, they will shape not only present prices but also future ones (thus making them "coherent").

So would thinking about one's Social Security number be enough to create an anchor? ... That's what we wanted to find out. ...

Prelec ... passed out forms... "Now I want you to write the last two digits of your Social Security number at the top of the page," he instructed. "And then write them again next to each of the items in the form of a price. In other words, if the last two digits are 23, write $23."

"Now when you're finished with that," he added, "I want you to indicate on your sheets whether you would pay that amount for each of the products."

When the students had finished, Prelec asked them to write down the maximum amount they were willing to pay for each of the products (their bids). ... The students enjoyed this exercise, but when I asked them whether they felt that writing down the last two digits of their Social Security numbers had influenced their final bids, they dismissed my suggestion. No way! ...

Did the digits from the Social Security numbers serve as anchors? Remarkably, they did: The students with the highest-ending Social Security digits bid highest, while those with the lowest-ending numbers bid lowest. The top 20 percent, for instance, bid an average of $56 for the cordless keyboard; the bottom 20 percent bid an average of $16. In the end, students with Social Security numbers ending in the upper 20 percent placed bids that were 216 to 346 percent higher than those of the students with Social Security numbers ending in the lowest 20 percent. ...

Social Security numbers were the anchor in this experiment only because we requested them. We could just as well have asked for the current temperature, or your shoe size. Any question, in fact, would have created the anchor.

Does that seem rational? Of course not. But when we make one decision, even when it's about an arbitrary number, we bring this history into our future decisions, and continue to make the same decisions over and over without going back and questioning their wisdom.

This suggests that if we just ignored the talk about recession, we would repeat our past behaviors and not deviate much from our pre-recession pattern of purchasing decisions. But when everyone is talking about recession, it's likely to make us stop, rethink our past decisions and feel that something needs to change. And so we change our patterns, start acting as if we're in a recession -- and thereby create one. ...

I wonder if this could generate sticky prices. If the anchor price is the price people are hearing about in local markets rather than the price consistent with the fundamental (long-run equilibrium) value, it would be more difficult for prices to return to equilibrium since people would be unwilling to depart from recent average prices even if the fundamental value is quite a bit different. A "good deal" would be assessed relative to average prices or prices people are hearing about rather than relative to the true value. Thus, I see this mechanism more as a way to propagate departures from equilibrium (i.e. this would make business cycles longer and perhaps more severe) than a fundamental driving force behind the departures from equilibrium. It's possible to imagine this mechanism creating a business cycle through self-fulfilling expectations - people believe a recession is coming so they begin to cut back on consumption and investment causing the problem they are worried about. But in, say, the case of the housing market bubble I would be unwilling to say this type of behavior is the driving force that caused the problem, but quite willing to acknowledge that something like this could create the sluggish adjustment we see in housing markets in response to other types of large, disruptive shocks.

    Posted by on Sunday, March 16, 2008 at 04:05 AM in Economics | Permalink  TrackBack (0)  Comments (10)

    TrackBack

    TrackBack URL for this entry:
    http://www.typepad.com/services/trackback/6a00d83451b33869e200e551269b1c8833

    Listed below are links to weblogs that reference Arbitrary Coherence:


    Comments

    Feed You can follow this conversation by subscribing to the comment feed for this post.

    -->