What is the Ratchet Effect?
- The ratchet effect, a Keynesian theory, states that once prices have risen in lockstep to a rise in aggregate demand, they do not always reverse when that demand falls.
- The ratchet effect first came up in Alan Peacock and Jack Wiseman's work: The Growth of Public Expenditure in the United Kingdom.
- The primary problem with the ratchet effect is that, in certain situations, people become accustomed to constant growth, even in markets that may be saturated.
Understanding the Ratchet Effect
Certain trends in economics tend to self-perpetuate, particularly for production. For example, if a store whose sales have been stagnant for some time adopts some company changes such as new managerial strategies, staff overhaul, or better incentive programs, and the store earns greater revenues than it had previously, the store will find it difficult to justify producing less. Since firms are always seeking growth and greater profit margins, it is hard to scale back production.
The ratchet effect 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 prior highest level of production.
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, such as during times of armed conflict 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.
The ratchet effect can also impact large-scale firm's capital investments. For example, in the auto industry, competition drives firms to be constantly creating new features for their vehicles. This requires additional investment in new machinery, or a different type of skilled worker, which increases the cost of labor. Once an auto company has made these investments and added these features, 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.
Similar principles apply to the ratchet effect from the consumer perspective because raised expectations escalate the consumption process. If a company has been producing 20 ounces sodas for ten years and then decreases their soda size to 16 ounces, consumers may feel duped, even if there is the commensurate price decrease.
The ratchet effect also applies to wages and wage increases. Laborers will rarely (if ever) accept a decrease in wages, but they may also be dissatisfied with wage increases that they considered insufficient. If a manager receives a 10% pay increase one year and a 5% pay increase the next year, he may feel that the new raise is insufficient although he is still getting a pay raise.
The primary problem with the ratchet effect is that in certain situations, people become accustomed to constant growth even in markets that may be saturated. Thus, the market may no longer satisfy consumer wants and needs, defeating the overarching purpose of economics.
The Ratchet Effect and Labor Markets
In labor markets, the ratchet effect presents itself in situations where workers, who are subject to performance pay, choose to restrict their output. They do this because they are anticipating that the company will respond to higher output levels by raising output requirements or cutting pay. This constitutes a multi-period, principal-agent problem. However, the ratchet effect in labor markets is nearly eliminated, when competition is introduced. This is true regardless of whether market conditions favor firms or workers.
Effects of the Ratchet Effect on Industry
The ratchet effect impacts how companies spend capital. In the automobile industry, for instance, competition drives car makers to constantly incorporate new features and twists on previous models. Once the company has invested in the machinery and personnel to produce the newer versions of their cars, they can't scale back production and fall behind the competition, as this would waste previous investments. Concurrently, pressures from the consumer market are also demanding newer and better models at cheaper prices.
The ratchet effect can also be observed in the airline industry, which has made frequent-flyer programs ever harder to terminate. In addition, home appliances constantly acquire more features as do new editions of software, etc. With all such improvements, the debate is ever-present as to whether added features truly improve usability, or simply increase the tendency for people to buy the goods.