Menu costs and asymmetric price adjustment

IntroductionThe reform of the Common Agricultural Policy has to respond to several challenges in general agricultural terms (climate change and European Union enlargement) and specifically in the dairy sector for developing more innovative and more marketoriented business models, ensuring high quality on milk supplied and sustainability of production, at right prices. A considerable volume of research and studies have recently been carried out on the assessment of price transmission, but most research is concentrated on various product markets in the United States (Fackler and Goodwin, 2001) and a few studies are focused in European markets (Meyer and Cramon-Taubadel, 2004; Serra et al. 2006; Ben-Kaabia and Gil, 2008). Some authors focus their work in developing countries (Rapsomanikis et al., 2003). In the EU, food supply chain research shows that imperfect and asymmetric price transmission is linked to market imperfections, concentration and agent's pricing policies (COM, 2009). Most empirical studies find little evidence of systematic imperfect price adjustments along the EU food chain, although this may happen in the short run in some specific sector/country situation. The studies of vertical and spatial price transmission have been used to infer a number of conclusions regarding the behavior of market linkages across different levels of the marketing chain. Some significant criticisms have been directed toward this line of study, because it assumes that the tests on price transmission are conducted without regard to the overall institutional and structural characteristics of the market. Goodwin (2006) concluded that cautions must apply to the methods and results. The first paper, specifically focused on dairy product prices, was presented by Kinnucan and Forker (1987). Stewart and Blayney (2011) have recovered the debate on asymmetric price transmission by the using the (threshold) error correction models on milk and cheese. Meanwhile, several studies have been focused on milk, cheese and dairy products, namely Serra and Goodwin (2003); Chavas and Mehta (2004); Jensen and Moller (2007); and Baumgartner et al. (2009). Serra and Goodwin, (2003) found positive asymmetries for the Spanish dairy market, Chavas and Mehta (2004) found that retail prices respond more strongly to wholesale price increases than to wholesale price decreases; their explanations are consumer search costs, retailers' menu costs and also imperfect competition at the retail level. Jensen and Moller (2007) detected weak price transmission, especially for milk. In their view, asymmetric price adjustment is caused by public intervention and product differences. More value added products show a higher degree of asymmetry. The European Union analyzes a range of different milk products for a variety of EU Member States. Instead of an error correction approach, a model in first differences was used to detect asymmetric price responses. In particular for Slovenia, United Kingdom, Denmark and Lithuania significant asymmetries are found. The Commission relates the positive asymmetries to the limited share of agricultural commodities into final food prices, inefficiencies in the market structure of the chain (either linked to imbalances in bargaining power and/or anti-competitive practices), and some adjustments constraints and costs (e.g. costs of changing prices for both producers and retailers, the slow price transmission due to long-term contracts between economic actors) (EC, 2009). Baumgartner et al. (2009) detected positive asymmetries for milk and butter. Stewart and Blayney (2011) studied price transmission over the food crisis from 2007 to 2009 in the United States of America (USA). They analyzed the nature of price transmission for whole milk and cheddar cheese, comparing results of different model specifications. Independent from underlying specification, they found positive asymmetries. Additionally, Stewart and Blayney (2011) stated for the lower processed product (whole milk) that the price pass-through is larger and that the process of error correction was active in the whole spectrum of observed disequilibria. …

This dissertation investigates retailers' pricing behavior by focusing on the retail gasoline market in Seoul, South Korea. The study consists of two chapters. The first chapter presents an empirical analysis of how gasoline stations change prices. One common feature of retail price changes is their periodic and lumpy nature. Various theories have been proposed to explain why retail prices are sticky, each focusing on different factors that influence how retailers set prices. Studies in macroeconomic theory indicate that optimal price adjustment patterns depend on the nature of costs involved in price adjustment. If a price change incurs a fixed cost (e.g., a "menu cost"), optimal price changes occur when the change in state variables exceeds a threshold, resulting in state-dependent price changes. Alternatively, if there is a fixed cost associated with acquiring information, it is optimal to make price adjustments with periodic regularity (time-dependent). Studies in industrial organization emphasize the role of market power and strategic interactions among retailers. Some studies in marketing science argue that retailers are more likely to maintain certain prices based on consumer psychology (e.g., those ending with the digit 9). Do some or all of these theories explain how Seoul's gasoline retail price changes? In the first chapter, I examine the empirical significance of time-dependent pricing, state-dependent pricing, market power, and psychological pricing in the estimation model and examine how these factors are correlated with each other. The estimation results show that the most dominant factor affecting pricing decisions is the time dependent pricing rule, and this tendency to follow the time-dependent pricing rule varies with retailers' local market power. The analysis of how frequently gas stations change prices helps to better understand another common empirical phenomenon concerning asymmetric changes in retail gasoline prices in response to changes in wholesale prices. Many studies find that increases in costs (such as oil prices) are passed through more quickly to retail prices than decreases in costs, a pattern known as "rockets and feathers". This literature is mostly based on the error correction model that assumes retail prices are a linear function of costs. The pricing behavior examined in the first chapter implies that changes in retail prices are nonlinear in changes in costs, as gas stations keep daily prices mostly unchanged despite continuous changes in costs. In the second chapter, I demonstrate the potential bias arising from using daily data for the "rockets and feathers" study. Recent studies on "rockets and feathers" tend to rely more on high-frequency data to avoid bias arising from the temporal aggregation of data. In this study, I investigate price adjustment patterns by estimating an error correction model using daily station-level data from the Korean gasoline market. I find that compared to those based on weekly data, the estimated adjustment patterns based on daily data exhibit greater variation, which may be attributed to model misspecification that fails to account for the essential feature of daily-level data: censored responses to cost changes. The empirical findings emphasize the need for careful model specification when investigating the price adjustment pattern with daily-level data. In additional analyses, I explore the effect of consumer search on adjustment patterns and find that consumer search may not be a primary driving factor behind asymmetric price adjustments.

In this paper we demonstrate that the menu-cost model implies that prices adjust asymmetrically to nominal-demand shocks and that the asymmetry is linked to the elasticity of demand as well as menu costs. These implications are tested using manufacturing and retailing panel data for the OECD countries. The empirical results give some support for the menu-cost model.

The assumption that nominal price adjustment is costly for firms (there are “menu costs”) has generated a stream of important theoretical papers over the last decade or so. Insofar as this literature generates asymmetric adjustments, it provides a theoretical underpinning for the (old) Keynesian assumption that nominal prices are more flexible upward than downward. Yet, the empirical evidence, while confirming that asymmetries exist, does not indicate the dominance of any particular form of asymmetry (see Dennis W. Carlton, 1986; Alan S. Blinder, 1991). In this paper we argue that the gap between theory and practice may be the result of the focus of menu-cost models on specific forms of market structure. Existing menu-cost models are based on the assumption of relatively uncompetitive market structures— monopoly, oligopoly, or monopolistic competition with a fixed number of firms. We widen the scope of the analysis by examining what we call a quasi-competitive industry and demonstrate that it displays a pattern of adjustment quite different from that found in other models. The Keynesian asymmetry is reversed, with nominal price being more flexible downward than upward. We suggest therefore that a relationship exists between market structure and the pattern of nominal price adjustment. Since there is presumably a variety of market structures, this may help explain the inconclusive empirical evidence. We model the most competitive market configuration compatible with menu costs: Bertrand oligopoly in a dynamic setting with free entry. It is assumed that (a) an incumbent in one period can continue to sell at its existing nominal price in the next period without incurring any additional menu cost, whereas an entrant would have to incur a menu cost; and (b) among the firms willing to sell at the lowest price in any given period, one is chosen randomly to sell the product. These simplifications enable us to abstract from matters—such as determining the identity of active firms—extraneous to our main concern of establishing a clean connection between market structure and the pattern of price (in)flexibility. To set a benchmark and to obtain a simple solution by backward induction, we begin by assuming a two-period time horizon. Then we extend the analysis to the case where the incumbent faces an ever-recurring threat of entry, that is, with an infinite horizon. This is the scenario we call “quasi-competitive.” Comparing these two extreme cases yields an intuitively appealing relationship between competitiveness and the pattern of nominal price adjustment. * Bennett: Department of Economics and Finance, Brunel University, Uxbridge, Middlesex, United Kingdom, UB8 3PH; La Manna: Department of Economics, University of St. Andrews, St. Andrews, Scotland, United Kingdom, KY16 9AL. This work developed out of earlier discussions with Subhashish Gupta. We are also grateful to V. Bhaskar, Huw Dixon, Elisabetta Iossa, Jonathan Thomas, and anonymous referees for very helpful comments. 1 For surveys, see N. Gregory Mankiw and David Romer (1991), Torben M. Andersen (1994), and Huw David Dixon and Neil Rankin (1994). 2 Models providing some support for the Keynesian asymmetry include Daniel Tsiddon (1993) and Laurence Ball and Mankiw (1994). However, Robert J. Barro (1972) and Mankiw (1985), among others, produce two-directional stickiness. The Tsiddon and Ball-Mankiw models are based on the assumption of positive trend inflation, whereby a firm that wishes to reduce its relative price finds that it can do so costlessly merely by keeping its nominal price unchanged. Conversely, a firm that wishes to raise its relative price finds that inflation widens the gap between its desired and actual nominal price, thereby providing a strong incentive to incur a menu cost and raise its nominal price. 3 A similar pattern of greater downward flexibility is found in kinked-demand-curve models, but there it occurs essentially by assumption; see, for example, Jean Tirole (1988 pp. 243–44). 4 A Bertrand duopoly model that yields the Keynesian asymmetry can be found in Per Svejstrup Hansen et al. (1996). Although their model and ours are not directly comparable (insofar as they consider real shocks and produce asymmetric price adjustments in the absence of menu costs), we conjecture that the opposite asymmetry generated by our model is due to our key assumption of free entry. 5 To establish the basic message of the paper it is not necessary to examine the more complicated case of a Tperiod model, where ` . T . 2.

Asymmetric pricing or asymmetric price adjustment is the phenomenon where prices rise more readily than they fall. We offer and provide empirical support for a new theory of asymmetric pricing in wholesale prices. Wholesale prices may adjust asymmetrically in the small but symmetrically in the large, when retailers face cost of price adjustment. Such retailers will not adjust prices for small changes in their costs. Manufacturers then see a region of inelastic demand where small wholesale price changes do not translate into commensurate retail price changes. The implication is asymmetric—a small wholesale price increase is more profitable because manufacturers will not lose customers from higher retail prices; yet, a small decrease is less profitable, because it will not lower retail prices; hence, there is no extra revenue from greater sales. For larger changes, this asymmetry in the behavior of wholesale price vanishes as the price adjustment cost is compensated by the increase in retailers’ revenue resulting from correspondingly large retail price changes. We present a formal economic model of a channel with forward-looking retailers and cost of price adjustment, test the derived propositions on the behavior of manufacturer prices using a large supermarket scanner data set, and find that the results are consistent with the predictions of our theory. We then discuss the implications for asymmetric pricing, channels, and cost of price adjustment literatures, as well as public policy.

Asymmetric price adjustment – evidence for India

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The Internet, Search, and Asymmetric Pricing: A Natural Experiment in Retail Gasoline

This study analyzes the asymmetric properties of domestic gasoline prices by considering the relationship between asymmetric price adjustments and volatility based on weekly data. The analysis reveals that, in the long run, changes in international oil prices are not fully transmitted to gasoline prices, while in the short run, gasoline prices adjust asymmetrically to fluctuations in international oil prices. Using an EGARCH model, it is observed that positive shocks lead to greater volatility than negative shocks, and the effect of international oil prices on gasoline price growth and volatility is found to be statistically insignificant. However, when international oil prices rise, the variance ratio of gasoline prices increases, thereby demonstrating a correlation between asymmetric price adjustments and price volatility. The study identifies search theory and ex-post adjustments as potential causes of asymmetry and proposes policy alternatives to mitigate this effect.

Dynamic pricing for deteriorating products with menu cost

Are anticompetitive behaviours rampant in global retail energy markets? A study of price elasticity, asymmetric price adjustment and rent-seeking

We investigate asymmetric price responses by considering a unique, highly disaggregate retailer‐ and product‐level time series at a major supermarket chain. We find asymmetry exists, but is limited in scope and there is no evidence of a pervasive chain wide asymmetric pricing strategy. To explain product level variation, we borrow from both economic and marketing perspectives to suggest menu costs, operational efficiency, competition, and consumer perceptions as important factors. The evidence suggests an efficiency‐based rationale for asymmetry. This study complements that of Peltzman (2000. J. Polit. Econ. 108(3): 466–502.) who found no systematic asymmetry in a study of the same data considered at a more aggregate level. Copyright © 2007 John Wiley & Sons, Ltd.

We study the price adjustment practices and provide quantitative measurement of the managerial and customer costs of price adjustment using data from a large U.S. industrial manufacturer and its customers. We find that price adjustment costs are a much more complex construct than the existing industrial-organization or macroeconomics literature recognizes. In addition to physical costs (menu costs), we identify and measure three types of managerial costs (information gathering, decision-making, and communication costs) and two types of customer costs (communication and negotiation costs). We find that the managerial costs are more than 6 times, and customer costs are more than 20 times, the menu costs. In total, the price adjustment costs comprise 1.22% of the company's revenue and 20.03% of the company's net margin. We show that many components of the managerial and customer costs are convex, whereas the menu costs are not. We also document the link between price adjustment costs and price rigidity. Finally, we provide evidence of managers' fear of antagonizing customers.I have no answer to the question of how to measure these menu change costs, but these [menu cost] theories will never be taken seriously until an answer is provided. Edward Prescott (1987, p. 113)Given the large number of theoretical papers that evaluate the implications of [price] adjustment costs, obtaining direct evidence that such costs are present seems crucial. Margaret Slade (1998, p. 104) © 2004 President and Fellows of Harvard College and the Massachusetts Institute of Technology.

Recent increases in the price of crude oil have led to a rise in the prominence of corn-based ethanol as an alternative source of energy. As a result linkages have been established between commodity and energy prices. The aim of this study is to determine if soybeans, corn, wheat, oil, and ethanol adjust their prices asymmetrically depending on whether their actual price is over- or under-predicted with respect to one another. This study’s goal of determining if asymmetric price relationships exist is accomplished by using monthly time series price data incorporated into a distributed lag error correction model distinguishing between positive and negative price difference and positive and negative values of the error correction term. The primary results of this study found that asymmetric price changes do occur in the commodity and energy markets. Interestingly, in all the asymmetric price adjustments that were found, with only one exception in the soybean-corn relationship, prices will adjust downward when the actual price of one variable is above its equilibrium price as determined by the price of another study variable and consequently would be expected to exhibit a downward adjustment in price in the following month.

We model the optimal price setting problem of a firm in the presence of both information and menu costs. In this problem the firm optimally decides when to collect costly information on the adequacy of its price, an activity which we refer to as a price "review". Upon each review, the firm chooses whether to adjust its price, subject to a menu cost, and when to conduct the next price review. This behavior is consistent with recent survey evidence documenting that firms revise prices infrequently and that only a few price revisions yield a price adjustment. The goal of the paper is to study how the firm's choices map into several observable statistics, depending on the level and relative magnitude of the information vs the menu cost. The observable statistics are: the frequency of price reviews, the frequency of price adjustments, the size-distribution of price adjustments, and the shape of the hazard rate of price adjustments. We provide an analytical characterization of the firm decisions and a mapping from the structural parameters to the observable statistics. We compare these statistics with the ones obtained for the models with only one type of cost. The predictions of the model can, with suitable data, be used to quantify the importance of the menu cost vs. the information cost. We also consider a version of the model where several price adjustment are allowed between observations, a form of price plans or indexation. We find that no indexation is optimal for small inflation rates.