In this post I am going to talk about price rigidities/stickiness. What do economists mean about price rigidities and how do we test them?
On the face of it this sounds pretty simple – if prices change often then there doesn’t seem to be much scope for them to be sticky. But when we think about it a bit more this isn’t true – and thinking about why it isn’t true can give us useful insights into the macroeconomy.
Heterogeneous price behaviours
The recent interview by Harvard economist Emi Nakamura on price dynamics, monetary policy, and this “scary moment in history”, inspired me to look at the issue of this post.
P.S. I recommend reading the interview , as I am sure everyone will discover something new from it.
Nakamura earned the John Bates Clark medal, awarded to the most promising economists under age 40. I’m a fan of Nakamura due to her clear way of articulating the economic ideas and concepts, without complexity and jargon. It’s a talent that I appreciate in economists.
Nakamura discusses how price behaviours are heterogeneous – namely that different sectors change their prices in different ways. For one sector , e.g. soft drinks companies constantly run sales on their products throughout the year, including tough periods suchs as the pandemic. However, for certain sectors ,e,g, restaurants and shops, price changes don’t occur much frequently, especially not during the COVID-19 shock.
We want to understand the reasons why prices are so reluctant to adjust given the shock in the economy.
Reasons why prices don’t change:
- Menu Costs: A menu cost is the catch-all term for all the different reasons why prices may stay fixed even when there is an incentive to change them. In other words, there is some cost of adjustment and this is termed a menu cost (eg a product with a RRP written on it or a menu that has prices on it will both have a cost associated with changing the packaging).
- Reputation element(cost) of increasing the prices: If activity picked up for a temporary reason there would be more customers trying to buy the product. The natural way of dealing with the excess demand for the firm would be to increase the prices. However, this may burn long-term bridges – existing clients may feel taken advantage of, hurting sales in the long-term. As a result, firms may keep prices fixed so maintain goodwill.
- Strategic elements: The interdependency between peoples choices can strongly influence how prices are set:
- These strategic complementarities between their prices mean that when faced by a shock firms may limit how much they want to change their price.
- Furthermore, in so far as there is a first-mover disadvantage due to the above reputation costs this can be even more of a concern.
- Finally, the game between firms can lead to tacit collusion which can strengthen or breakdown during the economic cycle. Let’s take an airline company as an example.
We can think about all three in terms of an example. Airlines normally compete in a form of oligopoly. The pricing is relatively non-fixed due to the use of online platforms. They compete with each other, so that they constantly change the prices to get a sudden gain in the market and to generate a brand and goodwill with customers.
However, the airlines recognise that this is a repeated game – and if they can work together on certain routes they can both earn a greater profit. As a result, they also have an incentive for tacit collusion – they do not announce collusion, but start setting prices with reference to each other in a way that boosts their profits.
In these situations the price of some goods, services, and factors of production may adjust while other don’t. That misallocation of prices then leads to a loss of efficiency and resources. This is not the end of the story though – these small misallocations can lead to larger macroeconomic costs, and once it propagates through the value chain the final decline in economic activity can be much larger than the small initial misallocations would suggest.
Flexible prices can still be rigid
These stories also help us recognise something else – price rigidity isn’t necessarily about the price not changing or being unable to change. It is about whether the specific price adjusts towards the “optimal” level quickly. This is why stickiness is a bit of a misleading work.
This can help explain why price stickiness is seen as key to Keynesianism, but the event that Keynes was explaining involved a sharp decline in nominal prices and wages – even though these prices fell the adjustment suffered from coordination failures and over a complex emergent macroeconomy this led to a significant drop in output.
Price stickiness of the form I am thinking about here was first discussed in The General Theory of Employment, Interest and Money, by John Maynard Keynes – but it relates to the debate between Ricardo and Malthus on the possibility of a general glut in the face of market pricing.
According to the Keynesian school, prices and wages are rigid as they don’t react to the shock in a way that would clear all product and factor markets (the optimal allocation of prices).
For instance, the price for Chanel bags go up every year by a certain amount. Even though prices are changing this is still an example of the price stickiness – as the change in the price is not occurring to clear the current market for Chanel bags. Many other drivers could be behind this, in my view it is fear of competitors’ entrance and the need to keep prices at a level buyers think is “fair” that restrains Chanel from a massive increase in prices in response to a temporary lift in demand. They have a reputation for increasing prices a certain amount each year, and any deviation of that strategy would have reputational consequences.
As a result, a study showing that firms often change their prices does not imply that price stickiness – and the misallocation this leads to – is not an issue. Instead it just tells us about the mechanisms that may cause the misallocation – if prices are constantly changing it is probably not menu costs that drive this misallocation, but instead the strategic interaction between firms or the timelines associated with their sales and production.
This can even imply that prices that are “more flexible” in terms of having fewer menu costs can actually create even more harmful misallocations due to these intertemporal and strategic concerns. As a result, policies that make it such that prices can move doesn’t imply that the markets will clear.
What this does tell us is that national economies are complicated – and a more sophisticated understanding of price setting behaviour shows us that the complex emergent nature of macroeconomic phenomena are hard to describe with our normal microeconomic tools. This is why macroeconomics takes the form it does – and why we need to be careful with the way we argue from aggregate values such as “goods and service prices” and “average wages”.