The citizen's judgments of prices and inflation

This chapter provides an introduction to the economic psychology of price and inflation judgments, focusing on the main findings and the more relevant psychological theories. The first part of the chapter (section 10.2) is devoted to the process of price evaluation. This is a fundamental process underlying individual economic and consumer behaviour, because purchase decisions usually imply a judgment of the price of a target product or service, and price is a fundamental evaluation dimension. Thus, it is important to understand the processes that lead individuals to deem a given price as cheap or expensive (Putler, 1992). In section 10.2 we will initially focus on theories centred on the construct of a reference price, defined as a benchmark price used in relative evaluation processes. These theories share the assumption that one or more reference prices, stored in memory or available in the external environment, are used to make sense of the target price via comparative evaluation processes (Monroe, 1990). We then briefly consider how prices are evaluated according to three psychological theories (prospect theory, decision by sampling, and norm theory), which provide further insight into evaluation processes and their effects. Finally, we will take into account the factors affecting retrieval of reference prices and briefly mention other aspects relevant to price evaluation. The second part of the chapter (section 10.3) is devoted to perceived inflation and inflation expectations. Inflation refers to changes in the value of money over time. From an individual's point of view inflation is revealed as changes in the cost of living (price inflation) and changes in income, for example wage inflation. Past price inflation is officially measured by the annual percentage change in the total cost of a basket of goods and services purchased by the typical consumer. In contrast, official measures of price inflation expectations are forecasts of price changes in the basket of goods - the most widely used being based on complex models of the economy. People's perceptions of past and expectations of future inflation have been found to differ from official statistics, often substantially (for a review, see Ranyard, Del Missier, Bonini, Duxbury and Summers, 2008). It is important to understand how this occurs, since, as we show, perceived inflation influences expected inflation, which in turn affects economic behaviour such as wage negotiations, borrowing, saving and spending. Furthermore, because of such effects on individual and household behaviour, and because public expectations are used to inform monetary policy, perceived and expected inflation indirectly affect the performance of the macro-economy (Armantier et al., 2013). After reviewing evidence of how people’s perceptions and expectations are formed we turn to research demonstrating some of their consequences. The chapter concludes by outlining some of the policy implications of the research reviewed.