Question

A group of people is offered two scenarios and asked which they would prefer: (A) a 3 percent wage decrease in a world with no inflation, or (B) a 3 percent wage increase in a world with 6 percent inflation. [LO 23.5] a. What is the increase or decrease in the real wage in option \(\mathrm{A}\) ? What about in option \(\mathrm{B}\) ? b. Knowing what you know about framing and loss aversion, which option do you expect more people to prefer? c. In light of your answer to \(b\), if you were an employer trying to cut real labor costs, would you prefer to have some inflation or no inflation in the economy?

Short answer

Real wages decrease by 3% in both options, but people may prefer option B due to framing effects.

Step-by-step solution

Understanding Real Wages

Real wage is the wage adjusted for inflation. It reflects the purchasing power of the wage earner. To determine if an individual's real wage increases or decreases, we compare the nominal wage changes to the rate of inflation.

Calculate Real Wage Change for Option A

In option A, the nominal wage decreases by 3% with 0% inflation. The real wage decrease can be found simply by noting the nominal decline, since there is no inflation to offset it. Thus, the real wage change in option A is -3%.

Calculate Real Wage Change for Option B

In option B, the nominal wage increases by 3%, but there is 6% inflation. To find the real wage change, we calculate: real wage change = nominal wage change - inflation rate = 3% - 6% = -3%. So, the real wage in option B also decreases by 3%.

Analyzing Preferences Based on Framing and Loss Aversion

In economics, framing effects and loss aversion suggest that people experience losses more heavily than equivalent gains. Since option A represents an apparent nominal "loss" and option B represents an apparent nominal "gain" despite both having the same real wage reduction, more people might prefer option B due to its perceived gain.

Employer's Preference

As an employer, preferring inflation can be advantageous in reducing real labor costs without cutting nominal wages. In an inflationary environment, you could minimize the perceived negative impact on employees and potentially avoid morale issues associated with nominal wage cuts.

Key concepts

Framing Effects

Framing effects refer to how people react to choices based on how they are presented, rather than just on the content of those choices. This can significantly impact decision-making, especially concerning wages and inflation.
In the given exercise, the presentation of option A (a nominal wage decrease) versus option B (a nominal wage increase amidst inflation) can affect preferences. Although both scenarios result in a real wage decrease of 3%, option B's framing as a gain might lead individuals to favor it.

• Option A is presented as a clear loss.
• Option B is framed as a gain, despite the real wage loss.

People tend to prefer gains over losses, even if the gain is only nominal and lacking in real value. This shows the power of framing, as people might choose the option with a perceived positive spin, despite no real financial advantage.

Loss Aversion

Loss aversion is an important psychological principle indicating that people prefer avoiding losses over acquiring equivalent gains. Essentially, the pain of losing is felt more strongly than the pleasure of gaining.
In the context of the exercise, both options A and B result in a real wage reduction of 3%. However, option A is perceived as a direct loss because of the nominal wage decrease.

• Option A clearly signals a loss.
• Option B, despite its real wage loss, feels like a gain due to the nominal wage increase.

People's natural tendency to avoid losses makes them likely to prefer option B. Potential losses trigger stronger emotional responses, guiding decision-making heavily influenced by loss aversion. This insight suggests that individuals might choose gains in a nominal context even if they translate to real losses.

Nominal vs Real Wages

Understanding the difference between nominal and real wages is crucial in assessing wage changes in the face of inflation. Nominal wage refers to the wage paid to an employee without any adjustment for inflation. Real wage, on the other hand, reflects the purchasing power of the nominal wage, adjusting for the impacts of inflation.
In the exercise:

• Option A features a nominal wage decrease of 3% with zero inflation, resulting in a real wage reduction of 3%.
• Option B presents a nominal wage increase of 3%, but a 6% inflation leads to a real wage reduction of 3%.

Both scenarios result in an identical real wage loss, but the framing makes option B appear more favorable.
This highlights the importance for individuals and employers to understand how inflation affects wages, as real wages determine true purchasing power, not nominal changes. Employers might find inflation beneficial when trying to cut costs, as it allows nominal wages to stay static or increase, keeping employees content while effectively lowering real wage costs.