Sticky Prices

Sticky Prices Example

We can see the implications of price stickiness more clearly with an example of a restaurant with sticky prices. This restaurant operates in the central business district of the city, and many of its customers are nearby office workers who go there for lunch and even after-work dinner. Many of the companies in the business district have just implemented hybrid-work and work-from-home policies, so there are a lot fewer office workers coming to work in the area now. In other words, the restaurant is now facing a negative demand shock.

One way to approach this problem is to drop the prices to attract more customers who would otherwise not come to this restaurant. But the restaurant does not want to change the prices for their dishes because it costs too much to change all their menus. So, the demand curve has shifted to the left, and the restaurant has kept the same prices. The result is less quantity demanded for its food.

Sticky Prices: Macroeconomic Implications

Because of sticky prices, firms will have to cut production levels instead of dropping prices in response to a negative demand shock. Cutting production usually means reducing the number of workers and their working hours.

Let's take a step back and look at this from the economy-wide perspective. There is some unexpected event that causes demand to be lower. Firms have to adapt to this lower demand by cutting production, so there is now less demand for all the downstream goods and services that go into the production of their goods. Now, these downstream firms face lower demand and have to cut their production levels as well, and this will affect the firms further downstream in the supply chain.

Furthermore, all these firms will lay off workers or reduce their workers' hours, which means that these workers will lose or have less income. Faced with less income, these workers have to cut their spending, which causes further reductions in aggregate demand. This illustrates that sticky prices can exacerbate the initial negative supply shock and make a recession more likely.

Sticky Prices: Demand Shocks and Inventory

Firms will try their best to predict what the future demand is and plan their productions accordingly. But, it is hard to always get things right, so many firms keep inventories as a way to deal with unexpected changes in the demand for their goods. If they face a sudden drop in demand, the firms can put some of the goods into inventory until demand picks up again. Similarly, if demand suddenly rises, the firms can retrieve previously produced goods from their warehouses to meet the higher demand.

Having inventories helps firms deal with changes in demand without constantly changing their production plans. Think about it, it would be such a hassle for firms - they would have to be constantly hiring and laying off workers. But inventory still doesn't solve the issue of demand shocks. If the demand shocks persist for a long period of time, such as in a deep recession, it will take a long time for demand to pick back up. When this is the case, firms cannot keep adding goods to their warehouses because there is a limit and it's costly to maintain a large inventory. Then, firms will have to slash production levels and lay off workers.

Sticky Prices Model Graph

We are economists, so let's model the situation of a restaurant that has sticky prices with a graph.

For simplicity, let's focus on one dish that the restaurant offers. In Figure 1, the restaurant offers this dish at a price of P₀. Because there are menu costs involved and the restaurant is unwilling to change the listed price, it essentially has a fixed price at P₀. In normal times, the business district sees a lot of office workers coming to work, so the demand for lunch and dinner is decent. But after the implementation of work-from-home and hybrid-work policies at many companies, the demand curve shifts from D₀ to D_L. Since the price remains the same, the shift in demand means that the restaurant is now only able to sell a lower quantity of this dish, at Q_L.

Fig. 1 - Sticky prices

On the flip side, we can also imagine the situation with a positive demand shock. Let's say that there are a lot of new companies that have moved into the business district, so there are a lot more office workers than before. The demand curve shifts from D₀ to D_H. With the price remaining the same, the new quantity demanded for the dish is higher, at Q_H.

Sticky Prices vs. Flexible Prices

Contrast the situation where we have sticky prices vs. when the prices are flexible. Figure 2 below illustrates the situation on the other end of the extreme: the prices are perfectly flexible with regard to the shift in demand. Because the price is completely flexible, the supply curve is vertical - the quantity supplied will remain the same while the prices change according to shifts in demand. With flexible prices, the restaurant will charge a price of P₀ during normal times, P_H when there is a positive demand shock, and P_L when it faces a negative demand shock. In all cases, the quantity supplied remains at Q₀.

Fig. 2 - Perfectly flexible prices

Take a second and think about what this means in terms of unemployment. Since this restaurant is able to change the price to adapt to the demand shocks that it faces, its output level is able to stay constant. This means that it is using the same amount of inputs throughout these demand shocks, including the number of workers that it has. No one has to lose their jobs because the demand curve happens to shift to the left.

But we don't have perfectly flexible prices in the real world. The Sticky-Price Theory points to that and says that this is the reason for cyclical fluctuation in unemployment levels. Firms are not able to adjust their prices to a lower demand, which means that they will have to cut their output in response. Firms have to lay off workers and cut working hours to adjust to the lower demand level and protect their bottom lines.

Sticky Prices: Oligopoly

One reason for sticky prices is the existence of oligopolies in certain markets.

Fig. 3 - The soda market is an example of an oligopoly

In the case of a negative demand shock, a firm may decide to drop the price of its products to attract more consumers to buy them. But for a firm in an oligopolistic market structure, that may not be as good of an idea. Remember that firms in an oligopoly have an interdependent relationship with each other. What one firm does with the price of its products will have a significant impact on the sales of the other firms.

If one firm drops its price, the other firms are very likely to follow suit and drop their prices as well. This means that it will not get as much of an increase in demand, but it will lose out on revenue from the purchases that it is already getting. This will mean a net loss for the firm.

In the case of a positive demand shock, a firm may want to raise the price to bring in more revenue. But a firm in an oligopoly needs to think about the other firms in the market. If it raises its price but the other firms don't follow, it risks losing its customers to the other firms.

Cooperation between oligopolistic firms is forbidden by laws to protect consumer welfare. Because of the lack of cooperation and the possibility of price wars, we can usually see sticky prices in oligopolistic markets. One notable exception is the world oil market which is largely controlled by a few big oil-producing countries. These countries form The Organization of the Petroleum Exporting Countries (OPEC) to cooperate on the supply of oil in order to target oil prices at their desired level.