by Joseph T. Salerno
Keynesian macroeconomists, old and new, have long criticized their classical and contemporary opponents for ignoring reality and treating the market economy as a giant auction in which prices are “perfectly flexible,” responding instantly to changes in supply and demand. This charge is wrong on two counts. First, all markets for outputs and inputs function precisely like auctions; and, second, auctions are not characterized by perfectly flexible prices but by an optimal degree of stickiness in prices that is determined by the market itself.
In this post I will deal with second point, because it has been generally neglected in responding to the Keynesians. To illustrate this point I will use the example of a one day on-site auction of 49 unsold condominiums at a 73-unit complex that recently took place in Auburn, Alabama and which I also happened to attend. (This auction is described in detail by Doug French.) The condo complex was designed as a “game-day center” to cater to out-of-town Auburn alumni and other fans who crowd the town and double its population during the seven or eight autumn weekends when the Auburn University football team plays its home games. Several of these complexes were started near the peak of the housing bubble and, like the one in question, were not ready for sale until after the bubble began to rapidly deflate in 2007.
As French describes, 12 of the 49 suites on the auction block were to be sold “absolute,” that is, at the price offered by the highest bidder, regardless of its height. The remaining 37 units were to be auctioned with a predetermined “reserve” price set by the seller. In the case of the latter, if the highest bid price for a particular unit did not exceed the reserve price, then the condo would be withdrawn from sale.
The condo units to be sold absolute were auctioned off first. The two deluxe two-bedroom suites originally advertised at $389,000 were sold for $260,000 and $245,000 respectively. The four two-bedroom models, initially priced at $237,000, sold for $125,000 to $135,000, while the four deluxe one-bedroom suites all garnered high bids of $105,000, a deep discount from their original $279,000 asking price. Smaller one bedroom units sold at even steeper discounts, with the $210,000 and $188,000 units fetching only $70,000 and the $63,000 respectively at the auction.
When all condos for absolute sale had been sold, the auctioneer initiated the bidding for condos the developer had designated for sale with reserve. The first unit was a two-bedroom deluxe condo and the bidding stopped at a price of $200,000, well below the lowest price ($245,000) that a similar unit had sold for in the absolute segment of the auction. What happened next was very odd: the auctioneer refused the bid price and abruptly declared the auction closed so as not to further “embarrass the property.” All remaining 37 units were withdrawn from sale. In an instant, prices had become absolutely rigid, leaving 37 condo units unsold. The reason for this development is clear. The owner was testing the market with the preliminary auction of the units for absolute sale, while possibly also raising needed cash to satisfy the minimum repayment demands of the banks that had extended him construction loans. To attain these purposes prices needed to be, and indeed were, perfectly flexible. However, after experiencing the state of the market with the initial sales and the highest bid received and refused on the first unit for sale with reserve, the auction company quickly ascertained that the developer’s reserve prices for the respective models would not be met and the auction was halted. These reserve prices were established because the developer of the complex was speculating that higher prices could be realized by withholding the remaining units from current sale and offering them in a future market. This aim was served by absolutely rigid prices. (Actually since the auction reserve prices were not announced, it may have been the case that the prices of the various models were not perfectly rigid at a given reserve price, but that for each of the several models there was a scale of increasing minimum prices at which progressively more units would have been sold until the stock was exhausted.)
In any case, our first conclusion is that auction prices are as sticky or as flexible as they need to be to accomplish the goals of the sellers. That is, in technical jargon, the supply curve may be: vertical (perfectly flexible prices); upward-sloping to the right beginning at a reservation price that exceeds zero (semi-flexible prices); or L-shaped with a horizontal segment up to the total stock available at which point the curve becomes vertical or upward sloping (absolutely rigid or sticky at the reserve price). The point to be emphasized is that the subjective purposes, expectations and plans of sellers directly determine the degree of flexibility of prices and the corresponding shapes of the supply curves. (Ultimately, of course, it is the present and anticipated demands of buyers which determine the sellers’ plans and thus condition the shape of the supply curve)
The second lesson to be derived from this auction market example is that the market clears and all gains from exchange are exhausted whether prices are perfectly flexible or absolutely rigid. The 37 condo units of the 49 units offered for sale that remained unsold at the auction were not unwanted surplus from the point of view of the developer, who actively pulled them off the auction block. At the end of the day all 49 units, whether sold or unsold were allocated by the market to their most “most capable possessors,” to use Böhm-Bawerk’s felicitous term. Thus sticky prices on an unhampered do not reveal market failure, unwanted surpluses and frustrated buyers and sellers—far from it, they reveal the sensitive adaptation of the pricing process to entrepreneurial discovery and planning.
In a subsequent post I shall argue that nominal price rigidities based on objective factors like “menu costs” are pure illusion. Like all “selling costs” the costs associated with changing prices associated with different pricing technologies previously chosen by entrepreneurs are sunk costs and do not affect pricing decisions on current stock.