While there are some explanations for the rockets and wings, none are very satisfying, he says Sergio Rebeloprofessor of economics at the Kellogg School. So, along with co-authors Miguel Santana, a graduate student in economics at Northwestern, and Pedro Teles, a professor at the Portuguese Catholic University, he set out to better understand the phenomenon by borrowing a framework used in psychology to model the decision-making process. .
This framework, popularized in Daniel Kahneman’s book Thinking Fast and Slowstates that we make decisions using one of two systems: either we run on autopilot and make choices based on past decisions that have worked out fairly well (system 1), or we think more deeply about our choices, which is mentally taxing but potentially leads us to a better decision (system 2).
In recent working paperRebelo, Santana, and Teles study how firms would behave if consumers made choices according to the dual system. They find that the resulting model provides a physical explanation for the rockets and wings phenomenon, as well as some other economic puzzles, such as ‘shrinkage’.
Borrowing a framework from psychology
According to the dual system framework, “when prices are stable, consumers are in a familiar environment and make decisions using automatic system 1,” says Rebelo. When prices change, however, the consumer is in an unfamiliar situation, so he activates system 2 and makes the mental effort to compare his regular brand with other alternatives.
All businesses raise prices when costs increase significantly, because otherwise they would have a negative margin. But when costs fall, firms with fixed sales have an incentive to keep prices constant, since price changes could lead customers to activate System 2 and potentially switch brands.
In this way, the strategic interaction between businesses and quasi-rational consumers creates the effect of rockets and wings.
Consumers can use a jerk
Consumers, of course, could benefit from activating System 2 from time to time.
If you decide which brand to buy and then don’t revisit that choice, you may not be getting the best deal, Rebelo explains. The goal is not to think about every purchase decision using system 2. that would be too taxing. And, indeed, the cognitive burden on consumers during hyperinflation is significant, as people spend a lot of brain power deciding what to buy.
But a little jolt every now and then through an inflationary or deflationary change in prices could actually help consumers, Rebelo says—adding a twist to current thinking about monetary policy.
“You [as a policymaker] i don’t really want to keep the prices fixed. You would want prices to change so that there is a jolt to the consumer,” he says. “It’s a trade-off: you don’t want people’s cognitive burden to hyperinflation, but you don’t want people stuck in their old ways, where the mistakes they made will be with them forever. You want to motivate people to optimize a little bit.”
Explaining some other puzzling pricing phenomena
The researchers’ model also helps explain some other strange pricing behavior.
Take shrinking inflation for example. This happens when companies keep the price of a product constant but reduce its size. They are willing to bear the cost of changing their packaging to avoid changing the sticker price. “It’s really weird,” says Rebelo, until you think of it as a way to prevent consumers from turning on System 2.
The model also explains why subscription services like Netflix or Amazon Prime change their prices so rarely. Even though there’s almost no cost to changing their price—it’s just an email to customers—the prices of these services have remained remarkably stable over the years.
The reasoning, says Rebelo, “is that they don’t want me to rethink the decision to sign up for Netflix.”
“We think this system 1 and system 2 framework is a good way to think about a number of economic phenomena,” says Rebelo.
Macroeconomics meets marketing
Another nice feature of the model, says Rebelo, is that it brings together two different fields: macroeconomics and behavioral psychology.
Marketers often use cognitive psychology to understand how consumers make their decisions and nudge them toward a particular choice. On the other hand, macroeconomists generally assume that consumers make optimal choices.
Rebelo says this dichotomy shows up if you walk from one section of Kellogg to the other.
“If you go to a marketing class, you hear about deviations from optimal behavior and how they can be used to market a product. If you take a macroeconomics class, you learn about models where consumers are incredibly rational,” says Rebelo. Instead of having a dichotomy, “perhaps we should unite these two perspectives.”
