Quantity Adjustment Costs and Price Rigidity

Abstract

It is by now well known that the presence of small lump sum costs of adjusting prices can lead to nominal price rigidity. However, the argument of adjustment costs could equally well be applied to quantities, thereby leading to rigid quantities. This paper examines the importance of adjustment costs on both prices and quantities in a dynamic monopoly model, where the firm has to decide whether it uses price or quantity or both as the adjustment mechanism to shocks which can be permanent or temporary. It is shown that there is more downward rigidity than upward and that this asymmetry is enhanced when the quantity adjustment costs consist of linear adjustment costs on top of the lump sum. Furthermore, prices seem to bear a relatively larger proportion of the adjustment burden when the shock is large, and vice versa for quantities when the shock is small. Finally, the firm may be rationed even when adjustment is carried out.