Sticky (economics)
Encyclopedia
Sticky, in the social sciences and particularly economics
, describes a situation in which a variable is resistant to change. Sticky prices are an important part of macroeconomic theory since they may be used to explain why markets might not reach equilibrium right away. Nominal wages are often said to be sticky in the short run. Market forces may reduce the real value of labour in an industry, but wages will tend to remain at previous levels in the short run. This can be due to institutional factors such as price regulations, legal contractual commitments (e.g. office leases and employment contracts), labour unions, human stubbornness, human needs, or self-interest. Stickiness normally applies in one direction. For example, a variable that is "sticky downward" will be reluctant to drop even if conditions dictate that it should. However, in the long run it will drop to equilibrium level.
Economists tend to cite four possible causes of price stickiness: menu costs
, money illusion
, imperfect information with regards to price changes, and fairness concerns. Robert Hall
cites incentive
and cost
barriers on the part of firms to help explain stickiness in wages.
Wages, prices, and employment levels can all be sticky. Normally, a variable oscillates according to changing market conditions, but when stickiness enters the system, oscillations in one direction are favored over the other, and the variable exhibits "creep"-- it gradually moves in one direction or another. This is also called the "ratchet effect". Over time a variable will have ratcheted in one direction.
For example, in the absence of competition
, firms rarely lower prices, even when production costs decrease (i.e. supply increases) or demand drops. Instead, when production becomes cheaper, firms take the difference as profit
, and when demand decreases they are more likely to hold prices constant, while cutting production, than to lower them. Therefore, prices are sometimes observed to be sticky downward, and the net result is one kind of inflation
.
Prices in an oligopoly
can often be considered sticky-upward. The kinked demand
curve, resulting in elastic price elasticity of demand
above the current market clearing price, and inelasticity below it, requires firms to match price reductions by their competitors to maintain market share.
Note: For a general discussion of asymmetric upward- and downward-stickiness with respect to upstream prices see Asymmetric price transmission
.
In time-dependent models price changes are staggered exogenously, so a fixed percentage of firms change prices at a given time. There is no selection as to which firms change prices. Two commonly used time-dependent models based on papers by John B. Taylor
and Guillermo Calvo
. In Taylor (1980), firms change prices every nth period. In Calvo (1983), firms change prices at random. In both models the choice of changing prices is independent of the inflation rate.
In state-dependent models the decision to change prices is based on changes in the market and are not related to the passage of time. Most models relate the decision to change prices changes to menu costs
. Firms change prices when the benefit of changing a price becomes larger than the menu cost of changing a price. Price changes may be bunched or staggered over time. Prices change faster and monetary shocks are over faster under state dependent than time. Examples of state-dependent models include the one proposed by Golosov and Lucas and one suggested by Dotsey, King and Wolman.
. Keynesian macroeconomists suggest that markets fail to clear because prices fail to drop to market clearing
levels when there is a drop in demand. Economists have also looked at sticky wages as an explanation for why there is unemployment.
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
, describes a situation in which a variable is resistant to change. Sticky prices are an important part of macroeconomic theory since they may be used to explain why markets might not reach equilibrium right away. Nominal wages are often said to be sticky in the short run. Market forces may reduce the real value of labour in an industry, but wages will tend to remain at previous levels in the short run. This can be due to institutional factors such as price regulations, legal contractual commitments (e.g. office leases and employment contracts), labour unions, human stubbornness, human needs, or self-interest. Stickiness normally applies in one direction. For example, a variable that is "sticky downward" will be reluctant to drop even if conditions dictate that it should. However, in the long run it will drop to equilibrium level.
Economists tend to cite four possible causes of price stickiness: menu costs
Menu costs
In economics, a menu cost is the cost to a firm resulting from changing its prices. The name stems from the cost of restaurants literally printing new menus, but economists use it to refer to the costs of changing nominal prices in general...
, money illusion
Money illusion
In economics, money illusion refers to the tendency of people to think of currency in nominal, rather than real, terms. In other words, the numerical/face value of money is mistaken for its purchasing power...
, imperfect information with regards to price changes, and fairness concerns. Robert Hall
Robert Hall (economist)
Robert Ernest "Bob" Hall is an American economist and a Robert and Carole McNeil Senior Fellow at Stanford University's Hoover Institution. He is generally considered a macroeconomist, but he describes himself as an "applied economist"....
cites incentive
Incentive
In economics and sociology, an incentive is any factor that enables or motivates a particular course of action, or counts as a reason for preferring one choice to the alternatives. It is an expectation that encourages people to behave in a certain way...
and cost
Cost
In production, research, retail, and accounting, a cost is the value of money that has been used up to produce something, and hence is not available for use anymore. In business, the cost may be one of acquisition, in which case the amount of money expended to acquire it is counted as cost. In this...
barriers on the part of firms to help explain stickiness in wages.
Examples of stickiness
Many firms, during recessions, lay off workers. Yet many of these same firms are reluctant to begin hiring, even as the economic situation improves. This can result in slow job growth during a recovery.Wages, prices, and employment levels can all be sticky. Normally, a variable oscillates according to changing market conditions, but when stickiness enters the system, oscillations in one direction are favored over the other, and the variable exhibits "creep"-- it gradually moves in one direction or another. This is also called the "ratchet effect". Over time a variable will have ratcheted in one direction.
For example, in the absence of competition
Competition
Competition is a contest between individuals, groups, animals, etc. for territory, a niche, or a location of resources. It arises whenever two and only two strive for a goal which cannot be shared. Competition occurs naturally between living organisms which co-exist in the same environment. For...
, firms rarely lower prices, even when production costs decrease (i.e. supply increases) or demand drops. Instead, when production becomes cheaper, firms take the difference as profit
Profit (economics)
In economics, the term profit has two related but distinct meanings. Normal profit represents the total opportunity costs of a venture to an entrepreneur or investor, whilst economic profit In economics, the term profit has two related but distinct meanings. Normal profit represents the total...
, and when demand decreases they are more likely to hold prices constant, while cutting production, than to lower them. Therefore, prices are sometimes observed to be sticky downward, and the net result is one kind of inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
.
Prices in an oligopoly
Oligopoly
An oligopoly is a market form in which a market or industry is dominated by a small number of sellers . The word is derived, by analogy with "monopoly", from the Greek ὀλίγοι "few" + πόλειν "to sell". Because there are few sellers, each oligopolist is likely to be aware of the actions of the others...
can often be considered sticky-upward. The kinked demand
Kinked demand
The kinked demand curve theory is an economic theory regarding oligopoly and monopolistic competition. When it was created, the idea fundamentally challenged classical economic tenets such as efficient markets and rapidly changing prices, ideas that underlie basic supply and demand models...
curve, resulting in elastic price elasticity of demand
Price elasticity of demand
Price elasticity of demand is a measure used in economics to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price. More precisely, it gives the percentage change in quantity demanded in response to a one percent change in price...
above the current market clearing price, and inelasticity below it, requires firms to match price reductions by their competitors to maintain market share.
Note: For a general discussion of asymmetric upward- and downward-stickiness with respect to upstream prices see Asymmetric price transmission
Asymmetric price transmission
Asymmetric price transmission refers to pricing phenomenon occurring when downstream prices react in a different manner to upstream price changes, depending on the characteristics of upstream prices or changes in those prices.The simplest example is when prices of ready products increase promptly...
.
Modeling sticky prices
Economists have tried to model sticky prices in a number of ways. These models can be classified as either time-dependent, where firms change prices with the passage of time and decide to change prices independently of the economic environment, or state-dependent, where firms decide to change prices in response to changes in the economic environment. The differences can be thought of as differences in a two-stage process: In time-dependent models, firms decide to change prices and then evaluate market conditions; In state-dependent models, firms evaluate market conditions and then decide how to respond.In time-dependent models price changes are staggered exogenously, so a fixed percentage of firms change prices at a given time. There is no selection as to which firms change prices. Two commonly used time-dependent models based on papers by John B. Taylor
John B. Taylor
John Brian Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University, and the George P. Shultz Senior Fellow in Economics at Stanford University's Hoover Institution....
and Guillermo Calvo
Guillermo Calvo
Guillermo Antonio Calvo is an Argentine economist who is currently Director of Columbia University's mid-career Program in Economic Policy Management in their School of International and Public Affairs ....
. In Taylor (1980), firms change prices every nth period. In Calvo (1983), firms change prices at random. In both models the choice of changing prices is independent of the inflation rate.
In state-dependent models the decision to change prices is based on changes in the market and are not related to the passage of time. Most models relate the decision to change prices changes to menu costs
Menu costs
In economics, a menu cost is the cost to a firm resulting from changing its prices. The name stems from the cost of restaurants literally printing new menus, but economists use it to refer to the costs of changing nominal prices in general...
. Firms change prices when the benefit of changing a price becomes larger than the menu cost of changing a price. Price changes may be bunched or staggered over time. Prices change faster and monetary shocks are over faster under state dependent than time. Examples of state-dependent models include the one proposed by Golosov and Lucas and one suggested by Dotsey, King and Wolman.
Significance in macroeconomics
Sticky prices play an important role in Keynesian, macroeconomic theory, especially in new Keynesian thoughtNew Keynesian economics
New Keynesian economics is a school of contemporary macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of New Classical macroeconomics.Two main assumptions define the New...
. Keynesian macroeconomists suggest that markets fail to clear because prices fail to drop to market clearing
Market clearing
In economics, market clearing refers to either# a simplifying assumption made by the new classical school that markets always go to where the quantity supplied equals the quantity demanded; or# the process of getting there via price adjustment....
levels when there is a drop in demand. Economists have also looked at sticky wages as an explanation for why there is unemployment.