The modern market is based on the following elements: prices, supply and demand, competition. Decrease in the level of the latter, as a rule, most often negatively affects the quality of goods and services. The prices for products are directly related to the volumes of production. The 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 leads to an increase in prices over time. In other words, the added value of products is growing. However, a decrease in demand does not always lead to a reduction 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 called this way. As you know, the ratchet wheel can move only one way. Approximately the same with prices in a market economy. They can grow, but it is difficult to reduce them. They are not always reduced even by a drop in demand.
A number of objective economic phenomena reflect the effect of ratchet. The graph of the price level and real production shows a decreasing curve. That is, the ratio between these two indicators is inversely proportional. The lower the price level, the more products will be produced, as the volume of created goods depends on the level of demand for them.
There are three factors that can help to understand the effect of the ratchet deeper. The first one is connected with the 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, getting more expensive goods, are poorer. This leads to the fact that the population begins to save on their expenses. Conversely, an increase in costs can be caused by a decrease in prices. The next factor is the interest rate effect. It grows with prices. The growth of rates causes a reduction in certain consumer spending and certain types of investment. The third factor is the effect of imported purchases. The higher the price of domestic goods, the better 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 reasons for this phenomenon, such as the effect of ratchet? And why prices are easy Grow, but hardly decline? The main reason is the limited competition. In such conditions, prices can dictate large firms, which benefit from receiving all the big profits. They determine the value of certain goods and try, if not raise it, then at least maintain at the current level. But how in this case to make a profit when demand decreases? This issue is solved by large firms by reducing supply and jobs at their production facilities. It is to be assumed that if competition were not severely limited, as in our time, prices would depend mainly only on the balance between supply and demand. The effect of the ratchet would probably have been negligible. However, this situation is unprofitable for monopolists and large firms. These organizations find mechanisms that allow them to save their profits even in the conditions of a falling demand for the goods that they produce and sell. When there is no macroeconomic equilibrium, the ratchet effect is particularly pronounced.