Ratchet Effect
Categories: Investing
The ratchet effect is like a positive feedback loop: something ratchets upward, which makes it ratchet even further upward, and on and on and on. You know, like the ratchet in your garage. You've got one, right? Should be right next to the hedge clippers.
The ratchet effect shows the psychological effect of going backwards with something, and how that’s untenable in many situations. In economics, this might be seen in continuously upping the price on a product, or upping the production, as a result of the previous levels.
For instance, Banana Co. makes yPhones, coming out with them every couple of years. They keep raising the prices on them, because they want the perception to be that getting the next yPhone is worth it. If the new yPhone sold for less than the last one, consumers might be ironically turned off to the idea of buying it, since it must be not-as-cool or not-as-high-tech if it’s cheaper.
This phenomenon happens within firms as well. A sales department might need to sell 30 thingamabobs every quarter…a target set based on last year’s performance. The sales peeps in the sales department know that next year’s target will be based on this year’s sales of thingamabobs. Because of this, the sales peeps are incentivized to sell 30 thingamabobs, but not much more.
If they happen to sell 50 thingamabobs per quarter on average for a year, then their boss will expect them to keep selling at least 50. Ratcheting up the expectations...that’s what bosses want to be able to do, and employees want to be able to keep on a...doable level.
