by Jerry O’Driscoll
In the recent discussion of Say’s Law, the issue of “sticky” prices came up. The term is the source of much confusion. The opposite of “sticky” prices is not “flexible” prices, but infinitely flexible prices. No matter how flexible a price, short of infinite flexibility, there will be quantity responses. Quantity responses are an inherent part of market economies, do not signal market imperfections, and do not typically trigger income-constrained processes.
Price setting incurs information costs. How does a producer or retailer know when to change his prices? Where does that information come from?
Normally, price changes are triggered when inventories either accumulate or decumulate at abnormal rates. If, for instance, a single retailer faces an increase in demand for his products (say dresses), he will be able to purchase more at current prices from his supplier’s inventory. If many retailers face an increase in demand, then the effects are pushed back to the production stage. Prices will start rising for all the inputs in the production of dresses and pass through all the production and distribution stages to retailers, who then raise his prices on the dresses beings sold to his customers. Each retailer will tell his customer that he is raising prices because his costs have risen. The economist understands, however, that the higher prices reflect higher final demand.
First quantity changes, then prices change.
Infinitely flexible prices in goods markets are difficult even to comprehend. Among other things, there would need to be instantaneous production. Less than infinitely flexible prices and inventories buffer against demand changes and avoid costly changes in production rates.
In many ways, the current recession is a classic inventory recession (build-up of goods to be worked off). Except the inventory build-up was of residences. Once the recession spread to other goods markets, response was very rapid. Indeed for about a year inventories of most goods were falling as demand fell. That suggests very rapid price responses — even anticipatory price cuts to clear inventory in the face of future drops in demand. That’s about as flexible as prices can get in the real world.
The problem with “sticky” price models is they prove too much. We would constantly be in depression if they had universal application. Demand is always shifting, triggering quantity responses and income-constrained processes. Since the economy is not always in depression, something other than less-than-infinitely flexible prices must be the culprit.