The role of prices in the economy
We can get a deeper understanding of why price stickiness reduces market efficiency (so that reducing stickiness creates value) by thinking about the role of prices in the economy. Consider the following puzzle. At any point in time, our society has a limited amount of any particular resource. A limited amount of computer programmers, bulldozers, office space, superbowl tickets, bandwidth, truck drivers, six packs, gasoline, flowers, financial capital, finance professors, electrical power … everything. But at the same time, the amount of those resources that could be used in productive projects or consumed by households, is essentially unlimited. So who decides which projects / households get the resources for their production / consumption? In particular who makes sure that the computer programmers go to the software projects where they will be most productive and that the flowers go to the buyers who value them the most?

The answer is that for the most part nobody decides. The economy is self organizing. The information that is needed for this self organization is … prices.

Prices allocate resources to their highest value use
Corporate managers and entrepreneurs create value by devising projects for which the value of the output exceeds the combined value of the inputs. That is obvious, but managers / entrepreneurs are creative and industrious and they devise more projects than can be supported by limited inputs. For example, an innumerable number of software projects are dreamt up, but they must compete for a limited number of computer programmers.

So what happens? The salaries of programmers are bid up. As they go up, the more marginal projects go from positive NPV to negative NPV. The salaries stop rising when the marginal project has an NPV of zero. It is change in the price of computer programmer time that not only determines which software projects go ahead, but ensures that the most productive (highest NPV) projects proceed.

The same reasoning applies on the consumer side. How do I know that I want a bunch of flowers instead a of six pack? (that's why we talk about households instead of individuals). I know by comparing the prices. The amount that I spend on different products is simply determined by their relative prices, my personal preferences for different products and how much I have to spend.

Price levels provide the information for decentralized decision makers
Who gets the fixed number of bunches of flowers for sale at the Hanover Co-op this week? The consumers who value them most highly. The price is usually set fairly high initially and then over the week the price is reduced to clear them before they lose their appeal. As the price comes down the consumers with the highest valuation are the first to buy.

In our market economy decisions are made by millions of individual producers and consumers. Decision making is decentralized and those decisions are made on the basis of prices. But it is more than that. Prices summarize the information in all those millions of decisions and prioritize them. When I am deciding whether to go ahead with my software project, am I trying to figure out how many other projects will demand computer programmers? No, because all the information that I need about supply and demand for programmers is summarized in the price of programmer time (assuming that I can write a long term employment contract).

Each decision maker looks at the prices of inputs and products and makes the production or consumption decision, without worrying about what other decision makers are thinking. Price levels determine which projects go ahead and who consumes the limited supply of consumption goods. Moreover, the allocation is optimal in the sense that the most productive projects go ahead and the consumption good goes to the consumers who value it most highly.

Price changes coordinate the re-allocation of resources
When technology changes, or consumer tastes change, or the supply of some fixed resource changes, or a tax is imposed, it is the change in prices that rebalances everything in an optimal way. Price changes bring about an efficient and optimal re-allocation of resources. So next time someone says to you 'in a market economy prices coordinate activity by optimally allocating resources', you know what they mean.

How do workers know that they should retrain as computer programmers? They make the decision on the basis of the cost of re-training and the relative price of their labor in their existing industry as compared to the software industry. So, resources move over time toward their most productive use.

What happens if the price of flowers rises in Hanover? In the short run, more flowers are shipped to Hanover and the price goes down in Hanover and up elsewhere. The NPV of flower growing projects also goes up. So in the long run some resources that were used elsewhere go into making flowers instead of something else. The public gets what the public wants and price changes bring it about.

Complications
Of course its not really quite like that. Lots of complications get in the way of our economist nirvana of perfectly competitive markets. Firstly, in most markets producers have some degree of market power (monopoly or [monopsony] power in the extreme). Secondly, there are transaction costs, such as search costs, but also costs of contracting and costs of asymmetric information, which in extreme forms may lead to collapse of the market altogether. Thirdly, there are externalities, positive and negative. Finally, there is the distorting role of the government.

Each of these problems with markets and the role of government are of fundamental importance. Nonetheless, prices play the most crucial role in resolving the mismatch, across markets and through time, between demand and supply. Moreover, freely varying prices lead to allocations that are optimal in the sense of allocating to the most productive projects and the most highly valued consumption. Still with me?

What does reduced price stickiness mean for economic efficiency?
When buyers and sellers make decisions on the basis of a flexible price, they are implicitly considering the decisions of other buyers and sellers because those decisions are summarized by the price. If prices are sticky then buyers and sellers do not have that summarizing information about each other's decisions. Instead they take decisions about buying and selling that do not, even implicitly, consider the actions of others. It is that breakdown in communication, through price changes, that leads to the inefficiencies of price stickiness. Changes in relative prices are the information life blood of the economy. The economy is choked when those price changes are restricted

An example: Deregulation of electricity prices.
In many countries electricity prices are set by regulators AND producers are expected to meet whatever demand arises, which is the same as saying that they are expected to keep the voltage constant. Demand varies in a predictable way throughout the day, throughout the year and with special events like half time at the Superbowl. There are also unanticipated demand shocks, such as unexpectedly hot days.

Producers must have enough capacity on standby to meet whatever demand arises. That means that large amounts of hugely expensive generating equipment is idle most of the time. Even worse, it takes time to fire up the most efficient coal burning plants, so they are often left spinning idle waiting for demand.

What is the problem here? Spikes in demand arise because consumers of electricity do not consider the level of demand (the aggregate decisions of other consumers) when deciding whether to turn on the washing machine. Why not? Because they don't have that information; that is, they don't have a flexible price that aggregates information about demand and supply across all buyers and sellers.

When prices are allowed to vary with the level of demand and supply, some buyers will shift their demand to another time when total demand is lower. How do they know when total demand is lower? -- the flexible price tells them. How do they know what the price is if it is flexible? -- that question brings the internet into the discussion. See the next article in this issue for much more on that.

Conclusion
Economics is the science of understanding how consumers, producers and the government, make choices about resources. For the most part individual decision makers have the private information that is needed to make optimal choices -- consumers know what their personal preferences are and firms know their own cost structure and how much they can sell at each price. What they each don't know, but need to know, is what choices are being made by other buyers and sellers. Prices are the essential summary information about the choices of other buyers and sellers. Moreover, when there is a change in total supply or demand, price changes get us to a new optimal equilibrium.

Stickiness in prices arise for natural reasons, as discussed in the next article, but still represent an inefficiency in the market. The inefficiency has two sources. Firstly, if prices can't adjust enough then either too much or too little will be produced (output inefficiency). Secondly, not all the market output will be produced by the most efficient firms and it won't go to the buyers who have the highest valuation of that output. Reducing price stickiness creates value by eliminating these market inefficiencies.