Sticky Prices Are Only Human

Sticky Prices Are Only Human

Sticky Prices Are Only Human

Moneybox
Commentary about business and finance.
July 7 1999 10:59 AM

Sticky Prices Are Only Human

Since Alan Greenspan and the New Economy killed inflation, you don't hear so much about the "stickiness" of prices, but not that long ago the debate over stickiness was a big deal. For markets to work in the clockwork fashion that neoclassical economics suggests they do, buyers and sellers should adjust their prices immediately in response to changes in supply and demand. Somewhere, after all, there's an optimal price that will let the seller make as much money as is humanly possible. That price may be high or low, depending on how many of the product the seller can sell, but it is out there and the market should let him find it.

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But when I went to the corner bakery Sunday to get a gelato, I didn't feel as if anyone was working too hard at price optimization. It was a very hot day, and there was a long line of people on the sidewalk waiting for the chance to order a gelato. (You're allowed inside the air-conditioned store only if you're ordering real bakery food.) But when I got to the front of the line, I was pleased to see that the prices were the same as always: $1 for a small cup, $1.25 for a medium, and $1.50 for a large. Easy to remember.

Now, there were long lines in front of that store, and in front of all the stores on the street selling gelato, all day long. Presumably, most of the people waiting in line would have willingly shelled an extra quarter for relief from the heat. But none of the stores raised their prices to take advantage of the demand, and I think it's safe to say that none of them contemplated it.

It's not that small-business owners aren't greedy. One glance at the prices in the local "we have everything" store, which benefits from having no competition from a real (that is, chain) store, will disabuse you of that notion. The gelato story isn't about the level of prices; it's about the stickiness of prices.

There are good reasons why prices don't change immediately in response to demand. It would be a pain to post the new prices (although since the bakery has a hand-painted sign, the costs here are probably not too immense). You run the risk of alienating customers, since even Americans feel that there's such a thing as price-gouging, and that charging what the market will bear is occasionally (that is, when someone other than them is doing it) nefarious. Changing prices might confuse customers, so that someone who wanted a gelato on a cool day might not drop by the bakery because he thought it would cost him $1.50 for a medium, even though on cool days it costs only $1.25. And then there's the possibility that bakery considers it's regular prices optimal.

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All of these factors are potentially important, and in different businesses they're more or less so. (Changing prices may be harder for restaurants, because they'd have to keep printing new menus, for instance.) But there's also something else at work, which I think you have to call the force of habit. In other words, the bakery charges this much for gelato because this is what it charges for gelato. That price will change over time, but often grudgingly. And while those other reasons are all economically rational in some sense, this one really isn't.

For a better example of what I'm talking about, look at the history of sharecropping in America. (Bill Miller, who runs the Legg Mason Value Trust mutual fund, told me this story.) Traditionally, sharecroppers took (take? are there still sharecroppers?) 50 percent of whatever they produced on their land and gave the other 50 percent to the landlord. No matter how productive or unproductive a given piece of land was, that was the percentage. But this doesn't make economic sense. A sharecropper stuck on a less fertile piece of land should go to the landlord and say, "I'll farm that guy's more fertile plot, and give you 60 percent, or 65 percent," since 35 percent of a productive piece of land is worth more than 50 percent of an unproductive piece of land.

But it never happened that way, and the few times landlords attempted to alter the system, their efforts were rejected. At some point, early on, 50 percent became established as the culturally acceptable price for sharecropping, and altering that became as difficult (which isn't to say impossible) as altering people's ideas about marriage, or family, or nationality. And while I don't think my bakery's commitment to that $1.25 gelato price is as strong as those sharecroppers' commitment to their 50 percent, I think there's something similar at work. I guess here in Carroll Gardens, Brooklyn, the market just isn't as efficient as it should be.