Who's Afraid of Sticky Prices?
Retailer J.C. Penney just announced a new pricing policy that will make its prices more rigid and other retailers are moving in that direction. Can depression and mass unemployment be far behind?
The linchpin of all varieties of Keynesian economics is the assumption that prices and wage rates are rigid and do not respond to changes in supply and demand, at least in the short run. As was demonstrated in 1944 in a famous article by Franco Modigliani, himself a Keynesian and later a Nobel laureate in economics, absent this assumption and the entire Keynesian edifice falls to the ground. It is because prices do not adjust immediately, say, to a fall in demand, that quantities must adjust, meaning that unsold goods pile up in inventories and an excess supply of labor goes unhired resulting in depression. A modern version of this story is also invoked by modern free bankers to justify their conclusion that the supply of money must be continually adapted to changes in the demand to hold money, lest recession and unemployment emerge. This version attributes the rigidity or “stickiness” of prices to objective factors like “menu costs,” which refer to the resource costs that the seller must incur every time he changes his array of product prices.
Of course our daily experience with coupons, early morning specials, restaurant blackboard specials, supermarket rewards cards, and so on makes this widely accepted story of intractable price rigidities ring hollow. But whether prices are rigid or flexible is really beside the point. The point is that the degree of price rigidity or flexibility is not determined by objective external factors such s menu costs, but is chosen by entrepreneurs as one of the dimensions of the good or service they bring to market. As Hans Hoppe once succinctly put it, “Prices are as rigid or as flexible as they need to be.” Entrepreneurial pricing policies are driven by and constantly adapted to the demands of consumers. For instance, the prices of movie theater tickets change very slowly and appear somewhat sticky because consumers prefer it that way; in contrast the prices of theater concession items like soft drinks, popcorn, and candy are continually varied by coupons, rewards cards and daily specials. Now back to J.C. Penney.
Large retailers and transportation firms often vary their pricing policies, trying to achieve the optimal degree of price flexbility in a changing economic environment. As reported this week, retailer J .C. Penney has introduced a radically new pricing policy in response to a shift in consumers’ shopping habits. With the increasing availability of shopping comparison apps for mobile electronic devices and the omnipresence of large Internet sellers like Amazon and eBay, consumers are increasingly shunning high mark-up items which they know will be eventually marked down. In the case of J. C. Penney, in 2002 an item that cost the retailer $10.00 was typically marked up to $28.00. That mark up was progressively increased and by 2011 a $10.00 item sold for $40.00. But despite the greatly increased mark up, the average price that a consumer paid for a $10.00 item rose only from $15.90 to $15.95 duing that same period Thus consumers have become more savvy and resourceful in their shopping practices. J. C. Penney has responded by slashing its prices by 40 percent and rounding all prices to the nearest dollar. This new “fair and square” pricing policy introduces greater simplicity but more rigidity into its pricing structure and involves getting rid of daily sales on multiple items and establishing three pricing tiers: every day regular prices; month-long specials; and “best prices” for clearance items on the first and third Friday of every month. Walmart has responded very differently via a highly flexible price policy of an Ad Match Guarantee in which it promises to match, under specified conditions, the prices advertised by competitors.
It remains to be seen whether consumers accept J. C. Penney’s new pricing structure. In 1992 American Airlines tried a similar scheme, slashing the number of prices in its computerized reservation system by 86 percent, from 500,000 to 70,0000. In the process the average fare was reduced by 38 percent and first class fares by 20 to 50 percent. The airline had estimated that the move would save $25 million annually and enable it to reallocate 600 employees to other tasks. No sale—air travelers rejected it and within six months the plan was rescinded.
Entrepreneurial experimentation with diverse pricing policies is an integral part of the market process . To single out sticky prices or, in technical jargon, “nominal rigidities” as a market failure and the root cause of macroeconomic fluctuations is just plain silly. It demonstrates the giant chasm that exists between lifeless macroeconomic models and the dynamic pricing processes of the real world.