The modern market is based on the following elements: prices, supply and demand, competition. A decrease in the level of the latter, as a rule, most often negatively affects the quality of goods and services. Product prices are directly related to production volumes. Supply and demand also depend on each other. For example, the more popular the product, the more often it will appear on the shelves.
High demand over time gives rise to price increases. In other words, the added value of products is growing. However, a decrease in demand does not always lead to lower prices. The cost of goods generally falls rarely. Such a phenomenon in the economy is known as the “ratchet effect”.
Let's see why this process was named that way. As you know, the ratchet wheel can move only in one direction. About the same with prices in a market economy. They can grow, but lowering them is quite difficult. They are not always reduced even by a drop in demand.
A number of objective economic phenomena reflect the effect of ratchet. The price level and real production graph shows a declining curve. That is, the relationship between these two indicators is inversely proportional. The lower the price level, the more products will be produced, since the volume of goods created depends on the level of demand for them.
There are three factors that can help you understand the ratchet effect more deeply. The first of them is connected with real cash of consumers. This is the so-called "wealth effect." The purchasing power of the population decreases with increasing prices. As a result, consumers, purchasing more expensive goods, get poorer. This leads to the fact that the population begins to save on their expenses. Conversely, an increase in costs may be caused by lower prices. The next factor is the interest rate effect. It is growing along with prices. Rising rates cause a reduction in certain consumer spending and certain types of investments. The third factor is the effect of import purchases. The higher the price of domestic goods, the more profitable it is to buy their foreign counterparts. However, in order for the economy to develop, it is necessary that exports exceed imports.
What are the causes of such a phenomenon as the ratchet effect? And why are prices easy
growing, but falling with difficulty? The main reason is limited competition. In such circumstances, prices can be dictated by large firms that are profitable to receive ever-greater profits. They determine the value of certain goods and try, if not to raise it, then at least maintain it at the current level. But how then to make a profit when demand decreases? Large firms solve this issue by reducing supply and jobs at their production facilities. It should be assumed that if competition had not been seriously limited, as in our time, then prices would mainly depend only on the balance between supply and demand. The ratchet effect would probably be negligible. However, this situation is disadvantageous to monopolists and large firms. These organizations find mechanisms that allow them to maintain their profits even in the face of falling demand for the goods that they produce and sell. When there is no macroeconomic equilibrium, the ratchet effect is especially pronounced.
