Earlier analyses explained why the level of wages or prices might affect the quality of the labor hired or of the good purchased. These effects have profound implications for the shape of the demand and supply curves, and they do imply that wages and prices may not adjust to market-clearing levels.[12] We are concerned here, however, with how economies respond to shocks. Efficiency wage theories, for instance, argue that while real wages may not adjust to a change in the supply of labor, they will typically change in response to other changes in economic circumstances, including information (about the productivity of workers, for example). In a dynamic economy, changes in prices and wages may convey information, about both the characteristics of a firm and changes in those characteristics. For instance, if a firm responds quickly to the lowering of prices by a competitor, this action may convey information about the firm’s willingness to meet its ability to withstand competition. By the same token, given asymmetries of information about a firms’ balance sheet, large changes in prices may convey information of particular importance to a firms’ creditors—for example, that the firm needs to liquefy assets quickly. (Firms facing the threat of bankruptcy are often forced to engage in quick inventory reductions; the fact that the signal is costly makes it a very effective signal.) It is the change in observable behavior that conveys information.
The information conveyed by changes in prices is all the greater when there are costs to changing prices, as in the menu cost literature. For in this case, the change conveys information that the shock to the environment (for example, to the net worth of the firm) is not small, but is greater than some critical threshold level.
Signaling theories thus suggest that to the extent that it is changes in behavior that convey relevant information, there will be strong rigidities in variables that are publicly observable. While inventories and much of the internal workings of firms are not observable, by their very nature, prices have to be at least partially observable to outsiders (to those engaging in the trade.) Similarly, layoffs may convey a strong signal, especially to other workers at the firm, that may induce those not laid off to commence searching for alternative employment. The recognition that various actions can convey information may provide an incentive for secrecy and for firms to take actions to otherwise obfuscate signals and their interpretations. Like other attempts to block information flows, this practice may interfere with overall economic efficiency.[13]
Much of the signal is related to deviations from norms. That is, if all firms are increasing prices by 3 percent, or if the firm has always increased its price in line with the rate of inflation, then deviations from either norm will convey information about the changed circumstances of the firm.[14] Since norms can differ in different countries, and can change dramatically, it may be difficult to relate price-setting processes just to fundamentals.[15]
The state of the economy may affect the information conveyed by a particular action, causing more rigidities in some circumstances than others. Thus, if the state of the economy is such that bankruptcy is a real danger, a firm may have a strong incentive to avoid signaling that it faces a higher probability of bankruptcy; as a result, prices may be relatively rigid in this situation. On the other hand, if the state of the economy is such that most firms are markedly decreasing prices, then the signal conveyed by a price decrease by a firm may be weaker—and it could simply be interpreted as reflecting lower costs of production or an effective response to competitive pressures.
Firms may, of course, be uncertain about the full implications of signals conveyed by wage and price changes, including how competitor firms, customers,[16] or suppliers (including creditors) will respond to those changes. This risk, combined with firm risk aversion, reinforces the reluctance to change prices. [17]