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RatchetEffect
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Ratchet Effect
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DEFINITION of 'Ratchet Effect'

Ratchet effect refers to escalations in production or price that tend to self-perpetuate. Once
productive capacities have been added or prices have been raised, it is difficult to reverse these
changes, because people tend to be influenced by the previous best or highest level of production.

BREAKING DOWN 'Ratchet Effect'

Certain trends in economics tend to self-perpetuate, especially on the production side. For example,
if a store whose sales have been stagnant for some time adopts some company changes - new
managerial strategies, staff overhaul, or better incentive programs - and the store earns greater
revenue than it had previously, it is difficult for the store to justify producing any less than the new
standard they have set for themselves. Since firms are always trying to grow and expand their profit
margins,, it is hard to scale back production at this point.
margins

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The ratchet effect can also impact large-scale firms in terms of their investments in capital. For
example, in the auto industry, competition drives firms to be constantly concocting new features for
their vehicles. This requires additional investment in new machinery or a different kind of skilled
worker,, which increases the cost of labor.
worker
labor. Once an auto company has made these investments and
added these features, it becomes difficult for themto scale back production. The firm doesn't want
to waste their investment in the physical capital they needed for the upgrades nor the human
capital in the form of their new workers (not to mention concerns about unnecessarily firing
workers).
Similar principles govern the ratchet effect from the consumer angle, in that raised expectations
make it difficult for the consumption process to scale back. If a company has been producing 20 oz.
sodas for ten years and then decreases their soda size to 16 oz., consumers may have the impression
that they've been duped or cheated, even with a commensurate price decrease.
The ratchet effect also applies to wages and wage increases. Laborers will rarely (if ever) accept
decreases in wages, but they may also be dissatisfied with wage increases if they are felt to be
insufficient. If a manager received a 10% pay increase one year and a 5% pay increase the next year,
he may feel that the new raise is insufficient, even though he's still getting paid more.
This example highlights the dangers of the ratchet effect -- in the manager's case, there may not
have been enough new business to make possible further increases, but he may still feel slighted.
The primary problem with the ratchet effect is that in certain situations, people become accustomed
to constant growth even in markets that may have been completely filled. This can leave people in a
position where the market is no longer satisfying their wants and needs, defeating the overarching
purpose of economics.

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Price Ratchet

A trigger that increases or decreases a price of a share/asset by a certain amount. If you ratchet up
the price of a stock, your actions are somehow causing the price of the stock to rise.

BREAKING DOWN 'Price Ratchet'

For example, many events that happen around the world, such as natural disasters or conflicts in
the Middle East, can affect the gas prices. When a natural disaster or a new conflict causes an
increase in gas prices, it is considered a ratchet.

Broad-Based Weighted
Average Ratchet

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RatchetEffect

A mechanism seen in early-stage, pre-public companies in response to a subsequent round of


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financing that involves issuing shares at a lower price than first-stage investors received. A broadbased weighted average ratchet almost always involves preferred stock,
stock, in which early investors
have a conversion price ("price X"), while a later round of investors receive preferred shares with a
lower conversion price ("price Y"). A weighted average price is calculated that will effectively reprice
the shares issued at price X and price Y to the value of:

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[(Price X) * (shares issued at Price X)] + [(Price Y) * (shares issued at Price Y)] / Total Outstanding
Shares on a Fully Diluted Basis

BREAKING DOWN 'Broad-Based Weighted Average Ratchet'

The company issuing the shares would prefer to not make any adjustments to preferred shares with
higher conversion prices, but most venture-capital groups and investors will insist on a clause that
protects their interests in the event that a lower round of financing (also called a "down round")
occurs in the future.
In a broad-based ratchet, all rights of ownership (real or potential) are counted in the denominator
of "total shares", whether they are preferred or convertible shares, warrants
warrants,, or options. In a narrowbased ratchet, only common stock outstanding is used to compute the weighted-average price of
shares to all investors.

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