Beyond the Cost of Price Adjustment: Investments in Pricing Capital

Abstract

The literature on costs of price adjustment has long argued that changing prices is a complex and costly process. In fact, some authors have suggested that we should think of firms' price-setting activities as producing prices, similar to the way firms use processes to produce goods and services. In this paper we explore one natural extension of this view, that besides observing costs of price adjustment, we should also expect to see firm-level investments in expenditures into these processes. We coin the term capital for these investments, and suggest that they can improve the efficiency of the production activities by both reducing the costs of adjusting prices, and improving the effectiveness of price adjustments in future periods. Using two types of data sources, we find compelling evidence of the existence as well as the importance of pricing in firms. The existence of firm-level capital has the potential of fundamentally altering the way we think about pricing and price adjustment in many areas of economics. It suggests looking toward the capital to decipher the likely degree and causes of price rigidity and its variation across price setters, markets, and industries. Moreover, capital introduces a new, higher-level, pricing decision made by individual firms. Decisions to invest in pricing compete with traditional investment decisions that have long been studied in economics, such as investments in plant, equipment, and R&D. Furthermore, since pricing is a choice variable, it implies that costs of price adjustment often used in models of price rigidity are endogenous. As such, pricing offers new insights into the micro-foundations of the costs of price adjustment. The most provocative implication of the new theory of pricing, however, is that the allocative efficiency of the price system itself may be determined endogenously by individual price setters who choose whether and how much to invest in pricing capital.