OPINION: Sticky prices are central to our understanding of what causes recessions

Michael Hicks, Ph.D., director Center for Business and Economic Research at Ball State University

Many folks have noted that gasoline and food prices have come down more slowly than they rose. Economist call these 'sticky prices' and they are a lot like the extra pounds many of us packed on during the holiday, they come off a lot more slowly than they came on. Understanding why prices are sticky might ease some frustration at the pump or grocery aisle.

Gasoline prices tend to rise and fall pretty quickly along with petroleum prices. While there are a few hiccups to this, like local gasoline mixture rules, prices here usually respond quite quickly. The reason for extreme fluctuations of petroleum prices are simply our old friends supply and demand (more on that in later weeks).

The grocery store pricing process is a bit trickier. Grocery stores and other retailers are very sensitive to gas price changes, since transportation is a huge part of the cost of their goods. Stores also find that changing prices is expensive. Economists call these 'menu costs'. So, a retail store will often avoid changing prices if they think higher costs for delivered goods are a passing phenomenon. They also don't want to change prices unilaterally and face a loss of local market share or damage their reputation. So, it is often months after their costs rise before grocery stores and other retailers raise prices. But, here's the frustrating part, once a local store finally raises prices almost everyone will do so at the same time. That causes the sticker shock that we saw last year.

Grocery stores will be just as unwilling to unwind the price changes (it may be months before the costs of goods decline as wholesalers recoup their early losses). Also, since retailers may have suffered losses for several months before increasing prices, they are all too happy to enjoy profits for several months after wholesale prices drop. They can hardly be faulted for that. Again, an even faster "follow the leader" activity engages as one local retailer lowers prices, the others follow.

Sticky prices are asymmetrically frustrating to consumers. We are angered only when prices don't drop fast. Sticky prices are central to our understanding of what causes recessions. The inability of prices to move smoothly and rapidly to the new levels that would clear markets cause producers to cut production - which in aggregate leads to a recession. The more sluggishly that prices adjust to the new reality, the longer and deeper the recession. (I wrote a whole doctoral dissertation on sticky prices in the 1990s and have waited a decade for them to be mentioned in the media.)