Price Rigidity

Definition

Price rigidity refers to the phenomenon where prices of goods and services remain relatively stable and do not adjust quickly in response to changes in demand or supply. This can occur due to various factors, including menu costs, contracts, and the behavior of firms in an oligopoly market structure, where companies may hesitate to change prices for fear of losing competitive advantage or triggering a price war.

5 Must Know Facts For Your Next Test

1. Price rigidity can lead to market inefficiencies since prices do not reflect the true equilibrium of supply and demand.
2. In an oligopoly, firms may choose to keep prices stable to avoid price wars, which can harm all competitors involved.
3. When a firm raises its prices, rivals are likely to maintain their prices, leading to a loss in market share for the firm that increased prices.
4. Conversely, if one firm lowers its prices, competitors are likely to follow suit, creating a scenario where prices may drop but not rise easily.
5. Price rigidity often results in longer periods of excess supply or demand before the market adjusts to new conditions.

Review Questions

• How does price rigidity affect competition among firms in an oligopoly?
  • In an oligopoly, price rigidity can lead to stable pricing among firms as they avoid changing prices due to fear of triggering competitive reactions like price wars. When one firm considers raising its prices, it risks losing customers to rivals who maintain their lower prices. This mutual understanding fosters an environment where firms prioritize non-price competition strategies such as advertising and product differentiation instead of engaging in aggressive pricing tactics.
• What role do menu costs play in contributing to price rigidity in various markets?
  • Menu costs represent the expenses incurred when firms change their prices, which can include physical costs like updating labels or more abstract costs such as losing customer loyalty. These costs can deter businesses from adjusting prices frequently, leading to a situation where even significant changes in supply or demand do not prompt immediate price adjustments. As a result, firms may prefer to maintain stable prices despite fluctuations in market conditions.
• Evaluate the implications of price rigidity on overall market efficiency and consumer welfare.
  • Price rigidity can significantly impact market efficiency by preventing prices from reflecting true supply and demand conditions. When prices remain stable despite shifts in the market, resources may be misallocated, leading to prolonged periods of excess supply or demand. This misalignment can hurt consumer welfare as they face higher prices during shortages or lower quality products during surpluses. Additionally, rigid pricing can stifle innovation and investment as firms become less responsive to changing market dynamics.

Related terms

Oligopoly:

A market structure characterized by a small number of firms that have significant market power, often leading to strategic interactions between them.

Menu Costs: The costs associated with changing prices, including the physical cost of updating price tags and the potential loss of customer loyalty.

Kinked Demand Curve:

A model that illustrates how firms in an oligopoly may face a demand curve that is more elastic for price increases and less elastic for price decreases, contributing to price rigidity.