In a recent blog post, I talked about different types of market failures and how they can change the way we see markets operate in practice. In this post, I covered externalities, information asymmetries, public goods, and monopolies.
Of course, this is not an exhaustive list of every possible type of market failure. These are just the ones that we most frequently run into with our work.
I wanted to talk today about another aspect of markets that don’t quite qualify as market failures but do play a big role in real world markets deviating from our simple economic models: “stickiness.”
When we talk about stickiness in markets, we refer to the fact that in many cases, prices don’t respond right away to changing market conditions. The best example of this is in the labor market. Many employees work under contracts that specify what their wages will be for some fixed duration.
It sounds crazy on its surface, but if every person was a totally rational economic actor and had perfect information, it might increase efficiency to allow people to negotiate their wages every single day. The reason this is crazy is because nobody is a perfectly reasonable economic actor, perfect information rarely exists, and there are significant transaction costs to renegotiation of contracts. Imagine the first hour of every work day being taken up by wage negotiations. Not only would it waste time, it would be mentally exhausting.
Instead, both employers and employees agree that signing contracts and having some certainty about the future is a better system. The reasons I wouldn’t classify this as a market failure are 1) I suspect that nobody would be better off without these types of contracts and 2) it does not lead to an inefficient allocation of resources.
At any single point in time, participants in the labor market can negotiate the price of labor and choose an efficient rate that takes into consideration some basic ideas about what both parties expect the economy to look like in the future. If the economy is generally stable, then a fair price today should largely be a fair price into the future.
Another key point about sticky markets is that they do eventually respond to changes in broader economic conditions, just not right away. This can create issues in the short run that public policy might need to address. Take the recent high inflation as an example.
There is mixed evidence about how well wages have kept up with inflation in recent years, but in general they have been able to keep pace overall. Still, we all remember how challenging it was for so many people in the early days of that high inflation.
Many people struggled with paying for basic needs because their wages were still stuck behind. Eventually they may have caught up, but by that point, the damage had been done for a lot of people.
While sticky wages can be a rational choice for businesses and employees, they do create problems that public policy can help address. A classic example is rising unemployment during an economic downturn. Because wages are sticky, companies are unable to reduce wages when they lose revenue. Instead, they have to lay off a portion of their employees.
Unemployment insurance is a direct response to this problem. By requiring companies to contribute to a shared fund, the government can provide a safety net for workers who lose their jobs due to these rigidities. This helps to stabilize the economy and reduce the harm caused by sticky prices.
Another market that is affected by sticky prices is housing. For many people, rents and mortgages make up the majority of their housing costs and those almost always come with long-term fixed payment schedules.
There are some variable housing costs like utilities that can fluctuate more regularly, but for most people participating in the housing market the price they pay is largely fixed. Again, this isn’t the same as a market failure because people participating in the market can account for future uncertainty and make efficient decisions in the short term. It does, however, constitute a departure from our classical economic models.
While we often focus on traditional market failures like externalities and monopolies, it's also important to understand other deviations from our simplified economic models. While sticky prices don’t cause the same type of inefficiency as a true market failure, it can still lead to short-term challenges that policymakers may need to address.