The modern market is based on the following elements: prices, supply and demand, competition. Lowering 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 are also dependent on each other. For example, the more popular the product, the more often it will appear on the shelves.
High demand over time creates an increase in prices. In other words, the added value of products is growing. However, a decrease in demand does not always lead to a decrease in the price level. The cost of goods generally rarely falls. This 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. Roughly the same with prices in a market economy. They can grow, but to reduce them is quite difficult. They are not always reduced even by a drop in demand.
A number of objective economic phenomena reflect the ratchet effect. The graph of price levels and real production displays 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 these is associated with real cash 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, will become poorer. This leads to the fact that the population begins to save on their costs. Conversely, an increase in costs may be caused by a decrease in prices. The next factor is the interest rate effect. It grows 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 prices of domestic goods, the more profitable 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 the phenomenon of the ratchet effect? And why prices are easy
grow, but hardly reduced? The main reason is limited competition. In such an environment, prices can be dictated by large firms, which benefit from increasing profits. They determine the value of certain goods and try, if not to raise it, then at least to maintain it at the current level. But in this case, how to make a profit when demand decreases? This issue is solved by large firms by reducing the supply and jobs at their production facilities. It is necessary to assume that, if competition were not seriously limited, as in our time, prices would depend mainly on the balance between supply and demand. The ratchet effect would probably be negligible. However, this situation is unprofitable for 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 they produce and sell. When macroeconomic equilibrium is absent, the ratchet effect is especially pronounced.