Ratchet Effect

DEFINITION of 'Ratchet Effect'

Ratchet effect refers to escalations in production or price 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 tend to be influenced by the previous best or highest level of production.

BREAKING DOWN 'Ratchet Effect'

Certain trends in economics tend to self-perpetuate, especially on the production side. For example, if a store whose sales have been stagnant for some time adopts some company changes - new managerial strategies, staff overhaul, or better incentive programs - and the store earns greater revenue than it had previously, it is difficult for the store to justify producing any less than the new standard they have set for themselves. Since firms are always trying to grow and expand their profit margins, it is hard to scale back production at this point. 

The ratchet effect can also impact large-scale firms in terms of their investments in capital. For example, in the auto industry, competition drives firms to be constantly concocting new features for their vehicles. This requires additional investment in new machinery or a different kind of skilled worker, which increases the cost of labor. Once an auto company has made these investments and added these features, it becomes difficult for them to scale back production. The firm doesn't want to waste their investment in the physical capital they needed for the upgrades nor the human capital in the form of their new workers (not to mention concerns about unnecessarily firing workers).

Similar principles govern the ratchet effect from the consumer angle, in that raised expectations make it difficult for the consumption process to scale back. If a company has been producing 20 oz. sodas for ten years and then decreases their soda size to 16 oz., consumers may have the impression that they've been duped or cheated, even with a commensurate price decrease.

The ratchet effect also applies to wages and wage increases. Laborers will rarely (if ever) accept decreases in wages, but they may also be dissatisfied with wage increases if they are felt to be insufficient. If a manager received a 10% pay increase one year and a 5% pay increase the next year, he may feel that the new raise is insufficient, even though he's still getting paid more.

This example highlights the dangers of the ratchet effect -- in the manager's case, there may not have been enough new business to make possible further increases, but he may still feel slighted. The primary problem with the ratchet effect is that in certain situations, people become accustomed to constant growth even in markets that may have been completely filled. This can leave people in a position where the market is no longer satisfying their wants and needs, defeating the overarching purpose of economics.