Price Ratchet

What Is a Price Ratchet?

A price ratchet is an event that triggers a significant change in the price of an asset or security. A company that beats analysts' estimates for quarterly earnings may experience a positive price ratchet, while a company that misses a negative ratchet.

Understanding Price Ratchets

A price ratchet is a trigger that increases or decreases the price of a share by a certain amount. For example, many events that happen around the world, such as natural disasters or conflicts in the Middle East, can affect the price of gas. When a natural disaster or a new conflict causes an increase in gas prices, it is considered a ratchet. Likewise, a disappointing consumer spending report might become a price ratchet that triggers a sharp decline in the stock market. If a government defaults on interest payments on its Treasury securities, this can also be considered a price ratchet because the event raises rates and triggers a decrease in stock prices.

Effects of Price Ratchets

Due to their effects on the market, events like natural disasters, wars and government defaults are of tremendous global interest. Determining the degree to which these price ratchets change asset prices is very important to most investors, and knowing what triggers changes in the market is one of the most fundamental goals of analysts.

Price ratchets can lead to a ratchet effect which refers to escalations in production or prices that tend to self-perpetuate. Once productive capacities have been added or prices have been raised, it is difficult to reverse these changes because people are influenced by the previous best or highest level of production.

The ratchet effect can impact large-scale firms' capital investments. For example, in the auto industry, competition drives firms to constantly create new features for their products, which leads to additional investment in new machinery or a different type of skilled worker, thus increasing the cost of labor. Once an auto company has made these investments, it becomes difficult to scale back production. The firm cannot waste their investment in the physical capital required for the upgrades or the human capital in the form of new workers.

Another more basic example of a ratchet effect applies to wages and wage increases. Workers will rarely accept a decrease in wages, and may also be dissatisfied with insufficient wage increases. For example, if a manager receives a 10 percent pay increase one year and a 5 percent pay increase the next year, she may feel that the new raise is insufficient even though she is still getting a pay raise.

The fundamental problem with the ratchet effect is the possibility for people to become accustomed to constant growth even in markets that may be saturated.

Origins of the Ratchet Effect

The ratchet effect first came up in Alan Peacock and Jack Wiseman's work: The Growth of Public Expenditure in the United Kingdom. Peacock and Wiseman found that public spending increases like a ratchet, following periods of crisis. Similarly, governments have difficulty in rolling back huge bureaucratic organizations created initially for temporary needs, e.g., at times of war, natural or economic crisis. The governmental version of the ratchet effect is similar to that experienced in large businesses that add myriad layers of bureaucracy to support a larger, more complex array of products, services, and infrastructure to support it all.