Price stickiness

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Definition

Price stickiness or sticky prices or price rigidity refers to a situation where the price of a good does not change immediately or readily to the new market-clearing price when there are shifts in the demand and supply curve. It could be of the following types:

  • Downward rigidity or sticky downward means that there is resistance to the prices adjusting downward. Therefore, when the market-clearing price drops (due to an inward shift of the demand curve or an outward shift of the supply curve), the price remains artificially higher than the new market-clearing level, resulting in excess supply (surplus).

Surplusabovemarketprice.png

  • Upward rigidity or sticky upward means that there is resistance to the prices adjusting upward. Therefore, when the market-clearing price rises (due to an outward shift of the demand curve or an inward shift of the supply curve), the price remains artificially lower than the new market-clearing level, resulting in excess demand (shortfall).

Shortfallbelowmarketprice.png

Explanations for price stickiness

Menu costs

Menu costs are the costs incurred by sellers in determining and conveying new price information (and can also include costs incurred by buyers in obtaining up-to-date information). Higher menu costs tend to make prices sticky both ways -- both sellers and buyers may prefer to transact at a non-equilibrium price if the resultant inefficiency is lower than the menu costs.

Psychology

An explanation offered, particularly in the context of wages, is that wages are rigid downward for the reason that reducing workers' wages is bad for employee morale (this goes beyond simply saying that lower wages are bad for employee morale. Rather, what this says is that the act of reducing wages itself carries bad consequences for morale, even if the new wage is high in absolute terms.) This effect is believed by some to operate at the level of nominal wages, i.e., a decrease in real wages achieved through inflation (with no decrease in nominal wages) may be less of a problem according to this theory. The theory is called nominal wage rigidity. The focus on nominal as opposed to real wages is an example of the money illusion.

Related phenomena

Price stickiness refers to a failure of buyers and sellers to adapt to new market conditions and arrive at the market-clearing price, rather than a regulatory impediment to their doing so. Regulatory impediments that may have somewhat similar effects (of creating a price that is different from the market-clearing price) are price ceilings and price floors. A binding price ceiling is a price ceiling lower than the market-clearing price, and it results in excess demand. A binding price floor is a price floor higher than the market-clearing price, and it results in excess supply.