Could You Explain How Deflation is Different From Companies Setting Prices to Reflect Input Costs and Efficiencies?

BY busadmin  November 24, 2008 at 11:15 AM EST

Woman seeks employment at a job fair; AP photo

Question/Comment: Dear Mr. Solman, I’ve read several articles recently discussing the risk of deflation. I think I understand broadly why deflation is bad for the economy in general. Could you explain how deflation is different from companies setting prices to reflect input costs and efficiencies?

Paul Solman: In a competitive market economy, companies are assumed not to SET prices (except when they have a monopoly due to a patent, say), but take what they can get.

Companies are ALWAYS trying to maximize efficiencies and input costs (who of us isn’t?), but that’s to undersell competitors. Thus, competition forces prices down – ultimately, to the cost of production, in theory, because you can’t produce at a lower cost for very long, right?

Deflation is simply the opposite of inflation: instead of rising, prices DROP. And like inflation, it’s bad for one basic reason: it doesn’t happen to everyone, evenly, all at once.

Think about it. If every price was suddenly half of what it had been yesterday, who cares? Deflation cut your income in half. If it did the same for the cost of milk, gas, land, your mortgage, your other debts, you’re no worse off than before. (The same thing would be true if prices doubled.)

Unfortunately, things like prices, wages, and debts all tend to be “sticky.” That is, they don’t move easily. They’re stuck where they are for different amounts of time – due to past promises, contracts, custom and lack of cooperation. They can’t read just willy-nilly.

When companies become short on cash they tend to make layoffs. However, if instead they made across the board cuts to salaries (for those high and low on the food chain), then the economic domino effect of rising unemployment could be avoided. Such salary cuts follow the prescription of Harvard economist Martin Weitzman, whose 1984 book “The Share Economy” argued for profit-and-loss sharing, economy-wide, as the antidote to layoffs. Thus, wages would rise and fall with the fate of the firm: no animals would be more equal than others.

I first interviewed Weitzman on the subject of wage-cutting v. layoffs in the early 1990s and now that his work may be more relevant than ever, I intend to do so again soon.

Until then, know that there are major consequences to layoffs: they are unfair, painful, and physically damaging (you have a 20 percent greater likelihood of a heart attack if you’ve been laid off once in your life) — plus each layoff leads to social service outlays and further FEAR, which cuts spending more than otherwise, which can lead to…more layoffs.

All of which seems to be happening right now.