Friday, 13 November 2009

Psychology of sticky prices

Do we implicitly extrapolate, unconsciously, from how we make a single trade to how we behave in markets generally?

We have a basic need to fix the price of a transaction for long enough for the trade to complete. If I agree to buy this beer from you for £3.40, and by the time it's finished pouring, the price might be £3.75 (or indeed £2.90) neither of us is likely to buy or sell much beer. For a transaction of this kind to work, the terms should be known in advance to both parties and remain the same for the duration of the trade.

And with our minds' amazing capacity to extrapolate, it's not such a big leap from there to the expectation that prices will remain stable over a slightly longer period of time (an hour, a day, a month, a year?)

Whatever learning mechanism creates this stability of expectations over the duration of a single transaction can surely be fooled into expecting the same thing for a bit longer.

This is reinforced by the tentative and exploratory nature of psychological valuation. We 'learn' the correct value for a transaction by deciding whether the object is worth what is being asked, and once we have made the decision it becomes available as a cognitive shortcut. That is, the learning is persistent - once we have made the decision once, we rely on it in future transactions. So if prices were to change, we'd resist the extra work of unlearning it in order to reconsider whether to buy the good at the new price. Price setters, in turn, instinctively know this and keep their prices stable where they can (apart from Amazon, it seems - but there are special circumstances there).

This effect strongly encourages price stability - and, in turn, has a powerful effect on market illiquidity. The sad consequence of this sticky prices phenomenon is: recession.

Most of our policy cures for recessions - monetary expansion, fiscal stimulus - are a workaround for this simple psychological fact. Maybe if we could change our minds a bit faster - or if some other cognitive assistance became available - the world economy would run a little more smoothly.

1 comment:

Tschäff said...

Don't forget the psychology of expected inflation. It can lock in inflation also leading to recession.