Price stickiness

Definition

Price stickiness refers to the resistance of prices to change, even when supply and demand conditions shift significantly. This phenomenon often leads to short-term market inefficiencies, as businesses may be slow to adjust prices in response to changing economic conditions. Price stickiness is a key feature in understanding how economic fluctuations occur and why some markets may not clear immediately.

5 Must Know Facts For Your Next Test

1. Price stickiness can result from several factors, including psychological barriers for consumers and firms, contractual obligations, and menu costs that make frequent price adjustments costly.
2. In a sticky price environment, businesses may prefer to maintain stable prices during economic downturns to avoid alienating customers, even if this means operating at a loss.
3. Price stickiness is particularly relevant during periods of economic shock, where quick adjustments are necessary but do not occur due to various constraints.
4. New Keynesian models incorporate price stickiness to explain why markets do not clear immediately and how this can lead to prolonged periods of unemployment or underemployment.
5. Central banks often take price stickiness into account when formulating monetary policy, as it influences the effectiveness of interest rate adjustments on stimulating the economy.

Review Questions

• How does price stickiness impact market efficiency and economic fluctuations?
  • Price stickiness negatively impacts market efficiency by preventing prices from adjusting quickly to reflect changes in supply and demand. This delay can lead to imbalances in the market, causing shortages or surpluses. During economic fluctuations, such as recessions or booms, the inability of prices to adjust rapidly can prolong economic instability, leading to higher unemployment rates and slower recoveries.
• Discuss the role of menu costs in contributing to price stickiness and its implications for business decision-making.
  • Menu costs refer to the costs associated with changing prices, which can deter businesses from frequently adjusting their prices. When businesses face significant menu costs, they may choose to keep prices stable even in the face of changing demand or input costs. This can lead to price stickiness, where prices do not reflect current market conditions. Consequently, firms may miss opportunities for profit maximization or fail to respond appropriately to competitive pressures.
• Evaluate the significance of price stickiness within the framework of New Keynesian economics and its implications for monetary policy.
  • In New Keynesian economics, price stickiness is a central concept that explains why markets do not always clear quickly and why aggregate demand plays a crucial role in determining economic output. The existence of sticky prices implies that monetary policy can have real effects on the economy. For instance, when central banks lower interest rates during a downturn, the delayed response of prices allows for increased spending and investment, thereby stimulating economic growth. This highlights the importance of understanding price stickiness when designing effective monetary policy interventions.

Related terms

menu costs: The costs incurred by firms when changing prices, such as printing new menus or updating software, which can contribute to price stickiness.

wage rigidity: The resistance of wages to adjust downward in response to changes in labor market conditions, which can exacerbate unemployment during economic downturns.

Keynesian economics: An economic theory emphasizing the role of aggregate demand in influencing economic output and prices, particularly when prices are sticky.