Price Stickiness

“Price stickiness” refers to the tendency of prices to adjust sluggishly to changes in the economy. Many economists believe that if wages and prices adjusted freely and quickly, then changes in the money supply should cause only proportionate changes in prices and the rest of the economy would feel no repercussions. With perfectly flexible wage and prices, a doubling of the money stock would double the average level of prices. According to this thinking, if doubling the money stock quickly doubled prices, other important variables such as the unemployment rate and the level of industrial production would remain unchanged.

The level of prices is measured by indices such as the consumer price index (CPI), the gross domestic product (GDP) deflator, and the producer price index (PPI). Because of price stickiness, the level of prices does not quickly mirror changes in the money stock. Therefore, changes in the money stock can bring about at least temporary adjustments in real variables such as the unemployment rate and industrial production.

In some markets, prices are highly flexible. For commodities such as corn and wheat, prices react quickly to changes in supply and demand. In these markets, the sellers have no control over the prices of the commodities they produce and sell. Farmers that grow these commodities are what economists call price takers. They have to take the market price and cannot charge one cent more without all the buyers disappearing. Corn farmers produce a standardized product and one farmer cannot claim that his corn is superior to the corn produced in other markets. Price stickiness does not occur on any appreciable scale in these markets.

It is in markets where producers and sellers set the price that price stickiness occurs. In industries populated with only a handful of sellers, competition becomes personalized rivalry. These sellers become fearful of price competition as a path to destructive price wars. The U.S. automobile industry of the 1950s and 1960s is a good example of an industry that shunned price competition. Instead, the U.S. automobile industry of that era favored competition based on styling, advertising, and gadgetry, unveiling new body styles yearly. In times of falling costs, individual sellers in these types of industries are afraid to cut prices for fear of sparking a price war. In times of rising costs, these sellers are afraid to raise prices out of fear that competitors will not raise prices.

In some industries, firms that set their own prices face a large number of competitors. Restaurants are a good example of this type of industry. The fear of price wars does not loom as large in these industries, but these firms may still find it costly to change prices too often. These firms bear what are called “menu costs.” Changing prices involves producing a new menu or catalogue. Menu costs can be as simple as the cost of remarking the prices of goods already on the shelf.

The regulation of prices accounts for some price stickiness. Utility rates for electricity and gas are still set by regulatory authorities. Union contracts make some wages rigid, which may contribute to some price rigidity among unionized employers. In addition, some prices are fixed by long-term contracts.

Economists have studied the frequency of price changes among firms that set their own price. One study found that nearly half the firms in a sample changed prices no more than once a year.

Some economists refuse to accept that price stickiness is the deciding consideration in the relationship between the money stock and real variables such as industrial production. They argue that the general tendency of producers to increase production when prices go up and vice versa leads to a positive correlation between money stock changes and output changes. This positive correlation occurs because producers tend to only see the prices of their own products going up, and are unaware that other prices and costs are increasing at roughly the same rate.