Ratchet Effect

What Is the Ratchet Effect?

The ratchet effect is an economic process that is difficult to reverse once it is underway or has already occurred. A ratchet is an analogy to a mechanical ratchet, which spins one way but not the other, in an economic process that tends to only work one way. The results or side effects of the process may reinforce the cause by creating or altering incentives and expectations among participants.

A ratchet effect is closely related to the idea of a positive feedback loop. In addition, like releasing a mechanical ratchet used to compress a spring, the reversal of an economic process that involves a ratchet effect may be rapid, forceful, and difficult to control.

Understanding the Ratchet Effect

The ratchet effect in economics refers to escalations in production, prices, or organizational structures that tend to self-perpetuate. This occurs because the process involved also changes the underlying conditions that drive the process itself. In turn, this creates or reinforces the incentives and expectations of the decision-makers involved in such a way that sustain or further escalate the process. This is very similar to a positive feedback loop, which is any pattern that reinforces itself.

The ratchet effect is named after the mechanical device known as a ratchet, which consists of a round gear and pivoting pawl that allows the gear to turn in one direction but not the other in order, for example, to turn a bolt or to compress a spring. In addition to the one-way nature of the process, a ratchet used to compress a spring can result in a build-up of stored energy in the spring that can be suddenly released if the ratchet is disengaged. In machines, this must be carefully controlled to avoid damage to the system by an uncontrolled release of energy.

Similarly, economic processes that involve a ratchet effect may be marked by a build-up of countervailing forces over time that can result in a rapid, and possibly disruptive, reversal of the process if the conditions that produce the ratchet effect are relaxed.

Applications of the Ratchet Effect

The ratchet effect can be seen in many areas of economics.

Political Economy

The ratchet effect first came up in Alan Peacock and Jack Wiseman's work: The Growth of Public Expenditure in the United Kingdom. Peacock and Wiseman found that public spending increases like a ratchet following periods of crisis.

Economist Sanford Ikeda later described how the reversal of this process is often characterized not by incremental ratcheting, but by dramatic or revolutionary swings toward smaller, less interventionist government that may be accompanied by general turmoil.

Businesses

The ratchet effect can also impact business activities and investments due to things such as sunk costs, relationship-specific assets, and path dependencies.

For instance, in the auto industry, competition drives firms to be constantly creating new features for their vehicles. This requires additional investment in new machinery, or a different type of skilled worker, which increases the cost of labor. Once an auto company has made these investments and added these features, it becomes difficult to scale back production. The firm may be unwilling to waste their investment in the physical capital required for the upgrades or the human capital in the form of new workers.

Let's look at another example. If a store whose sales have been stagnant for some time adopts some changes, such as new managerial strategies, staff overhaul, or better incentive programs, and then earns greater revenues than it had previously, the store will find it difficult to justify producing less. Since firms are always seeking growth and greater profit margins, it is hard to scale back production. 

The business version of the ratchet effect can also be similar to that experienced in government bureaucracies, where agents — in this case, managers — have an incentive to support a larger, more complex array of products, services, and infrastructure to support the operations they manage.

Consumers

Similar principles apply to the ratchet effect from the consumer perspective because raised expectations escalate the consumption process. If a company has been producing 20 ounces sodas for ten years and then decreases their soda size to 16 ounces, consumers may feel duped, even if there is a commensurate price decrease.

Labor Markets

The ratchet effect also applies to wages and wage increases. Laborers will rarely (if ever) accept a decrease in wages, but they may also be dissatisfied with wage increases that they considered insufficient. A manager who receives a 10% pay increase one year and a 5% pay increase the next year may feel that the new raise is insufficient, even though it still represents a pay raise.

In labor markets, the ratchet effect also presents itself in situations where workers, who receive performance pay, choose to restrict their output. They do this because they are anticipating that the company will respond to higher output levels by raising output requirements or cutting pay.

This constitutes a multi-period, principal-agent problem. In this situation, if the workers increase their output, they reveal information about their productivity to the principals, who will then ratchet up their demands for worker output. However, the ratchet effect in labor markets is nearly eliminated when competition is introduced. This is true regardless of whether market conditions favor firms or workers.