What Is Price Stickiness?
Price stickiness refers to the tendency of market prices to adjust slowly or not at all in response to changes in underlying economic conditions, such as shifts in supply and demand or input costs. This concept is a cornerstone of macroeconomics, particularly within New Keynesian economic models, which seek to explain why markets may not always clear instantly, leading to short-run economic inefficiencies. When prices are sticky, they do not immediately reflect their optimal level, causing a temporary disequilibrium in the market.
History and Origin
The concept of sticky prices has roots in the work of economist John Maynard Keynes, who, in his seminal work The General Theory of Employment, Interest, and Money, first highlighted that nominal wages and prices might not be perfectly flexible, particularly in a downward direction. This rigidity, often observed during economic downturns, prevents immediate market adjustments that classical economic theory would predict. While Keynes initially focused more on wage stickiness, the idea was later extended to product prices.
Modern discussions of price stickiness gained significant traction with the development of New Keynesian economics in the 1970s and 1980s. Economists like N. Gregory Mankiw and Laurence Ball further formalized theories explaining price rigidity, often attributing it to factors such as menu costs and imperfect information. Their work, as detailed in papers like "A Sticky-Price Manifesto," provided microeconomic foundations for the observed macroeconomic phenomenon, showing how individual firm-level decisions could lead to aggregate price stickiness5.
Key Takeaways
- Price stickiness is the resistance of market prices to change quickly in response to shifting economic conditions.
- It is a core concept in modern macroeconomics, explaining why economies may experience prolonged periods of unemployment or output fluctuations.
- Factors contributing to price stickiness include menu costs, implicit contracts, imperfect information, and strategic interactions among firms.
- Price stickiness often leads to market inefficiencies, as prices may not reflect the true equilibrium of supply and demand.
- Understanding price stickiness is crucial for policymakers, especially central bank officials, when formulating monetary policy.
Interpreting Price Stickiness
Price stickiness is interpreted as a friction in the economy that prevents swift market clearing. When prices are sticky, nominal shocks—such as changes in the money supply—can have real effects on output and employment, rather than just affecting the overall price level. For instance, if aggregate demand falls unexpectedly, but prices do not adjust downwards immediately due to stickiness, firms may reduce production and lay off workers instead of lowering prices. This can lead to a recession or a period of higher unemployment.
Conversely, during periods of rising costs or strong aggregate demand, sticky prices can delay the transmission of inflationary pressures, potentially leading to a more gradual rise in the general inflation rate. The degree of price stickiness varies across different goods and services, influencing how quickly and smoothly various sectors of the economy respond to shocks.
Hypothetical Example
Consider a small coffee shop that prints physical menus and advertises its prices on large, outdoor signs. Each time the shop wants to change the price of a coffee, it incurs "menu costs"—the expense of reprinting menus, updating digital displays, and replacing physical signs.
Suppose the cost of coffee beans, a key input, suddenly drops significantly. In a perfectly flexible market, the coffee shop would immediately lower its coffee prices to reflect the reduced cost and attract more customers. However, due to price stickiness, the owner might hesitate. The cost of updating all their pricing materials (the menu costs) could outweigh the potential short-term increase in profit from selling more coffee at a slightly lower, more optimal price. As a result, the coffee price remains "sticky" at the old, higher level for a period, even though economic conditions suggest a lower price would be more efficient for both the shop and its customers. This delay in adjustment demonstrates how even small frictions can lead to price stickiness and a temporary deviation from market efficiency.
Practical Applications
Price stickiness has significant practical implications for businesses, consumers, and macroeconomic policymakers. For businesses, the decision to maintain stable prices can be influenced by several factors. Surveys of firms indicate that price-setting behavior is often shaped by considerations like customer relationships, explicit or implicit contracts, and the anticipation of competitors' responses. For 4example, a company might avoid frequent price changes to foster customer loyalty and reduce customer dissatisfaction.
From a policy perspective, central banks closely monitor price stickiness as it directly impacts the effectiveness of monetary policy. If prices are highly sticky, changes in interest rates or the money supply will have a more pronounced and prolonged effect on real economic variables like output and employment before nominal prices adjust. This is a core reason why central banks can influence the business cycles in the short run. For instance, if prices are slow to fall during a downturn, a central bank might lower interest rates to stimulate aggregate demand and encourage spending, thereby mitigating the severity of the recession.
Limitations and Criticisms
While price stickiness is a widely accepted concept in modern macroeconomics, it is not without limitations and criticisms. Some economists argue that observed price stickiness might not always translate into significant policy implications or deviations from economic models assuming flexible prices. For example, some theories suggest that even with sticky prices, money is neutral, meaning changes in the money supply do not affect real economic activity in the long run.
Ano3ther critique revolves around the specific causes of price stickiness. While "menu costs" are often cited as a primary reason, some research suggests that these costs might be too small to account for the magnitude of observed price rigidities, especially at the aggregate level. Instead, factors like imperfect information or strategic interactions among firms (e.g., reluctance to be the first to cut prices for fear of signaling weakness or triggering a price war) may play a more dominant role. Furt2hermore, the degree of stickiness can vary significantly across industries and over time, making it challenging to apply a single, overarching theory. For example, some studies on wholesale gasoline prices have found that strategic considerations, rather than just menu costs, are crucial in explaining their dynamics.
1Price Stickiness vs. Nominal Rigidity
Price stickiness refers specifically to the resistance of individual product or service prices to change. It is a microeconomic phenomenon that contributes to broader macroeconomic conditions.
Nominal rigidity, on the other hand, is a more encompassing term in macroeconomic theory that includes not only sticky prices but also other nominal variables that are slow to adjust, such as nominal wages (wage stickiness). Nominal rigidity implies that economic agents face some costs or constraints when adjusting nominal values (prices or wages), which prevents instantaneous market clearing. Therefore, price stickiness is a form of nominal rigidity. The distinction lies in scope: price stickiness is about specific prices, while nominal rigidity covers any nominal variable that is resistant to change, leading to a disconnect between nominal and real rigidity.
FAQs
Why do prices tend to be "sticky downward" rather than upward?
Prices are often more "sticky downward" (resistant to falling) than "sticky upward" (resistant to rising) due to factors like firm reluctance to signal lower quality by cutting prices, concerns about employee morale (in the case of wages), or the desire to maintain profit margins. Consumers also tend to resist price increases less than price decreases once accustomed to a certain price point.
What are "menu costs" in the context of price stickiness?
Menu costs are the literal and figurative expenses incurred by businesses when they change their prices. These can include the physical cost of reprinting menus or price tags, updating computer systems, advertising new prices, or even the loss of customer goodwill due to frequent price adjustments.
How does price stickiness affect monetary policy?
Price stickiness means that changes in a central bank's monetary policy (e.g., adjusting interest rates or money supply) can have a temporary impact on real economic variables like output and employment. If prices were perfectly flexible, monetary policy would only affect the nominal price level without changing real economic activity. This temporary "non-neutrality of money" allows central banks to influence the economy in the short run to combat recession or excessive inflation.
Is price stickiness always considered negative?
While price stickiness can lead to market inefficiencies and prolonged adjustments to economic shocks, some argue it can have perceived benefits for businesses and consumers. For businesses, stable prices can foster customer loyalty and simplify pricing strategies. For consumers, predictable prices reduce uncertainty in budgeting. However, from a macroeconomic efficiency perspective, the inability of prices to adjust rapidly can hinder the economy's ability to reach optimal macroeconomic equilibrium.
What is the relationship between price stickiness and rational expectations?
In macroeconomic models, the assumption of price stickiness is often combined with the concept of rational expectations, where economic agents use all available information to make the best possible forecasts about the future. Even with rational expectations, if firms face costs or constraints in adjusting prices, stickiness can still occur. This combination forms the basis of many modern New Keynesian models, which explore how rational agents behave in markets with nominal rigidities.