Price-setting Model Research Articles

Price rigidity and price dispersion: evidence from micro data

We use large unpublished data set about the prices by store of 381 products collected by the Israeli Bureau of Statistics during 1991–1992 in the process of computing the CPI. On average 24% of the stores changed their price where the average is over products and months. Using the standard calculation this would imply that on average prices remain unchanged for 4.1 months. We argue that the standard calculation may suffer from a large aggregation bias due to Jensen's inequality and our best estimate suggests that prices remain unchanged on average for 7.9 months. We then assess the importance of price rigidity in generating price dispersion. We find no evidence that price rigidity as measured by the frequency of nominal price changes is related to price dispersion. We also find no evidence that a shock to the inflation rate increases price dispersion. These findings are not consistent with standard versions of the staggered price setting model but are roughly consistent with a simple version of the uncertain and sequential trade model.

Multiproduct Cournot oligopoly

We present a general Cournot model in which each flrm may sell multiple quality-difierentiated products. We use an upgrades approach, working not with the actual products, but instead with upgrades from one quality to the next. The prop- erties of single-product Cournot models carry over to the supply of upgrades, but not necessarily to the supply of complete products. A flrm's product line is determined by the properties of demand, its costs, and competitor characteristics. For symmet- ric flrms, these determinants reduce to returns to quality and changes in demand elasticity as quality increases. For asymmetric flrms whose (potentially endogenous) technological capabilities are deflned by their maximum feasible qualities, gaps in product lines are determined precisely by the capabilities of lesser rivals. Strategic commitment to product lines prior to quantity competition is considered. Incentives to so commit are markedly difierent from those under price-setting models.

A Puzzle of Microstructure Market Maker Models

This study addresses the empirical viability of microstructure models of dealer price setting. New evidence is presented rejecting these models' specifications of how information asymmetry and inventory accumulation affect dealer pricing. This rejection is consistent with those of other dealer-level empirical studies. This study suggests a new modeling option may be to reconsider optimal price setting while relaxing assumptions that specify incoming orders as the only component through which dealer inventories evolve. This approach is consistent with inventory evolution data and with general equilibrium models' assumptions about currency markets.

Partial Indexation, Trend Inflation, and the Hybrid Phillips Curve

This paper proposes a full description of the Calvo price-setting model based on partial prices indexation and studies the interaction between partial indexation and trend inflation. We show that using a hybrid version of the Phillips curve partly decreases the risks of overestimate due to the omission of trend inflation. We also provide new evidence on the fit of the hybrid Phillips curve for the Euro area and the United States over the period 1970-2002. The GMM-West estimates suggest that (i) a full indexation scheme is not data consistent whereas a partial indexation scheme allows a good fit and (ii) forgetting trend inflation induces overestimating by approximately 3-4 percent of the probability to not change the price, for reasonable values of trend inflation.

Is Moderate-to-High Inflation Inherently Unstable?

The data across time and countries suggest that moderate-to-high inflation and inflation volatility are highly correlated. This paper examines the effect of trend inflation on the ability of the monetary authority to ensure a determinate equilibrium and macroeconomic stability in a sticky-price model. Trend inflation increases the importance of future marginal costs for current price-setters in a staggered price-setting model. The greater importance of expectations makes it more difficult for the monetary authority to ensure stability; in fact, equilibrium determinacy cannot be achieved through reasonable specifications of nominal interest rate (Taylor) rules at moderate-to-high levels of inflation (for example, at levels below 8 percent per year). If monetary policymakers have followed these types of policy rules in the past, this result may explain why moderate-to-high inflation is associated with inflation volatility. It also suggests a revision to interpretations of the 1970s. At that time, inflation in many countries was at least moderate, which can contribute to economic instability. The results suggest that some moderate-inflation countries that have recently adopted inflation targeting may want to commit to low target inflation rates

Sticky Prices, Coordination and Enforcement

Price-setting models with monopolistic competition and costs of changing prices exhibit coordination failure: in response to a monetary policy shock, individual agents lack incentives to change prices even when it would be Pareto-improving if all agents did so. The potential welfare gains are in part evaluated relative to a benchmark equilibrium of perfect, costless coordination; in practice, since agents will still have incentives to deviate from the benchmark equilibrium, coordination is likely to require enforcement. We consider an alternative benchmark equilibrium in which coordination is enforced by punishing deviators. This is formally equivalent to modeling agents as a cartel playing a punishment game. We show that this new benchmark implies that the welfare losses from coordination failure are smaller. Moreover, at the new benchmark equilibrium, prices are upwards-flexible but downwards-sticky. These last results suggest that the dynamic behavior of sticky-price models may more generally depend on the kind of imperfect competition assumed.

Sticky Prices, Coordination and Enforcement

Price-setting models with monopolistic competition and costs of changing prices exhibit coordination failure: in response to a monetary policy shock, individual agents lack incentives to change prices even when it would be Pareto-improving if all agents did so. The potential welfare gains are in part evaluated relative to a benchmark equilibrium of perfect, costless coordination; in practice, since agents will still have incentives to deviate from the benchmark equilibrium, coordination is likely to require enforcement. We consider an alternative benchmark equilibrium in which coordination is enforced by punishing deviators. This is formally equivalent to modeling agents as a cartel playing a punishment game. We show that this new benchmark implies that the welfare losses from coordination failure are smaller. Moreover, at the new benchmark equilibrium, prices are upwards-flexible but downwards-sticky. These last results suggest that the dynamic behavior of sticky-price models may more generally depend on the kind of imperfect competition assumed.

Sticky Prices, Coordination and Enforcement

Price-setting models with monopolistic competition and costs of changing prices exhibit coordination failure: In response to a monetary policy shock, individual agents lack incentives to change prices even when it would be Pareto-improving if all agents did so. The potential welfare gains are in part evaluated relative to a benchmark equilibrium of perfect, costless coordination; in practice, since agents will still have incentives to deviate from the benchmark equilibrium, coordination is likely to require enforcement. We consider an alternative benchmark equilibrium in which coordination is enforced by punishing deviators. This is formally equivalent to modeling agents as a cartel playing a punishment game. We show that this new benchmark implies that the welfare losses from coordination failure are smaller. Moreover, at the new benchmark equilibrium, prices are upwards-flexible but downwards-sticky. These last results suggest that the dynamic behavior of sticky-price models may more generally depend on the kind of imperfect competition assumed.

Endogenous Cycles and Menu Costs: A Dynamic Macroeconomic Model of Monopoly

We present a dynamic model of price setting in which price adjustments are costly for the monopolist. The general price level changes endogenously due to welfare changes. For the resulting two‐dimensional dynamical system the existence of a continuum of stationary points is proven. Furthermore, simulations show that endogenous cycles of output can occur.

Prices and unit labor costs: a new test of price stickiness

This paper investigates the predictions of a simple optimizing model of nominal price rigidity for the dynamics of inflation. Taking as given the paths of nominal labor compensation and labor productivity to approximate the evolution of marginal costs, I determine the path of prices predicted by the solution of the firms’ optimal pricing problem. Model parameters are chosen to maximize the fit with the data. I find evidence of a significant degree of price stickiness and substantial support for the forward-looking model of price setting. The results are robust to the use of alternative forecasting models for the path of unit labor costs, alternative measures of marginal costs, and alternative specifications the model of price staggering.

What Goes Up Must Come Down? Asymmetries and Persistence in Bank Deposit Rates

This paper contains a model of price setting in the presence of heterogeneous customers, explaining why bank interest rates respond sluggishly to some extended movements in market interest rates but not to others. Price (the bank interest rate) is likely to change only slightly with cost (the market interest rate) when the price-cost margin is already large and to be responsive when the price-cost margin is relatively small. The model is tested using data on interest rates offered for bank deposit instruments during 1987–2001. The results support the theoretical model, indicating that customer behavior plays a role in bank interest rate decisions.

Low inflation, pass-through, and the pricing power of firms

Recently there has been a significant decline in the degree to which firms ‘pass through’ changes in costs to prices, a decline that is frequently characterized as a reduction in the ‘pricing power’ of firms. The decline appears to be associated with the decline in inflation in many countries. The decline has important implications for monetary policy because it affects both forecasts of inflation and the effects of changes in monetary policy on inflation. Some have argued that the decline in pricing power helped to keep inflation low in the face of apparently strong demand pressures in the United States in the late 1990s. This paper puts forth the view that the decline in pass-through or pricing power is due to the low inflation environment that has recently been achieved in many countries. First, a microeconomic model of price setting is used to show that lower pass-through is caused by lower perceived persistence of cost changes. Evidence is then presented showing that inflation is positively correlated with persistence of inflation, suggesting that the low inflation itself has caused the low pass-through. An economy-wide model consistent with the micromodel is then presented to illustrate how such changes in pricing power affect output and inflation dynamics in favorable ways, but can disappear quickly if monetary policy and expectations change.

The new pharmaceutical policy in Italy

Pressed by an impressive series of corruption scandals and by a change of attitude towards cost-containment, the Italian pharmaceutical sector's regulatory environment was radically changed in 1994. Regulatory power was concentrated on a national technical body (CUF) and a new set of measures was taken, including a nationwide drug expenditure budget, a redefinition of both the positive list and the cost-sharing rules, and new price-setting models. As a result, in the period 1993–1996, nominal expenditures decreased by about L 1600 billion (ECU 83.6 billion at 1997 exchange rate), that is from 13.3% to 11.0% of current National Health Service (NHS) expenditure. While in the 1980s Italy was one of the most generous countries in funding pharmaceuticals, it is now one of the most parsimonious. Although the overall pharmaceutical market shrank in 1994 and 1995, a substantial part of NHS drug-bill savings resulted from cost-shifting from the public sector to patients, mainly because physicians have not aligned their prescribing behaviour to the new positive list. The new Italian approach to containing pharmaceutical costs has been certainly effective, at least in the short run. However, new relevant issues are emerging regarding the fall of NHS pharmaceutical coverage, the centralised nature of the Italian pharmaceutical policy and the gap between scientific based policies and actual prescribing behaviours.

Barometric price leadership

Barometric price leadership refers to situations in which a price leader acts as a barometer of prevailing market conditions for other firms in the industry. In this paper, a model of price setting with costly information acquisition is analyzed. It is shown that the unique equilibrium outcome is for one firm to acquire information and become a price leader, while the other firm does not purchase information and becomes a follower. In contrast to most previous work, leadership in this model is due to the informational setting, not the price-setting mechanism as, with symmetric information, the unique outcome is the symmetric Bertrand equilibrium.

The Lead of Output Over Inflation in Sticky Price Models

Output growth is negatively correlated with inflation, and detrended output is positively correlated with inflation, in the major North American and European economies. In addition, output growth and detrended output lead inflation. I explore the consistency of these correlations with three models of price adjustment: the partial adjustment model, a staggered price setting model, and the P-bar model. The ratio of the variance of supply to demand shocks necessary to match the pattern of output- inflation correlations can be ranked across the three models; the P-Bar model requires the lowest ratio, and the partial adjustment model requires the highest ratio. These results reveal that the recent burst of researchers using the partial adjustment model will find a larger role for supply shocks than alternative models of price rigidity.

The Consequences of Appointment Methods and Party Control for Telecommunications Pricing

While the economic approach to the politics of regulation emphasizes the importance of organized economic interests in shaping policies, political institutions in which regulatory agencies are embedded may also have significant effects. By including both economic influences and characteristics of political institutions in a model of price setting by state regulators, this paper demonstrates that both shape regulatory behavior in the telecommunications industry. Whether commissioners are elected or appointed, whether they face confirmation by a legislature, and whether a single party controls both executive and legislative branches of state governments influence the level of prices charged for basic services.

On the Efficiency of Matching and Related Models of Search and Unemployment

This paper describes a simple framework for evaluating the allocative performance of economies characterized by trading frictions and unemployment. This framework integrates the normative results of earlier Diamond-Mortensen-Pissarides bilateral matching-bargaining models of trade coordination and price-setting, and consists of a set of general conditions for constrained Pareto efficient resource allocation that are applicable to conventional natural rate models. To illustrate, several conventional models of the labour market are reformulated as matching-bargaining problems and analyzed using this framework.

A model of duopoly and meeting or beating competition

This paper analyzes the use of ‘meeting and beating competition’ clauses in duopoly markets. A differentiated-products, price-setting model is considered, in which firms have the option of precommitting themselves to contracts which bind their own price to be some prespecified function of their competitor's price. The analysis establishes conditions under which these contracts facilitate oligopoly coordination, under which they result in price discrimination, and under which they can actually be procompetitive.

The Existence of Nash Equilibria in Reaction Functions for Dynamic Models of Oligopoly

Consider Cournot's stability analysis of his mineral spring duopoly [Cournot, 1838]. Each of the two firms believes that its rival's output in the next period will simply equal that observed currently. Profit maximization yields reaction which are explicitly dynamic and are assumed to govern the actual evolution of the system. Cournot proved that the system is asymptotically stable in this simplest case. Cournot's result was shown by Theocharis [1960], not to generalize to three or more firms. Fisher [1961] discusses more general cost and demand functions than those used by Cournot. Even in the case considered by Cournot, however, there is an obvious conceptual objection. Each firm's output will generally vary from one period to the next, flagrantly violating its rival's conjecture. Some of James Friedman's work [especially 1968, 1973, 1976 and 1977] might best be viewed as an attempt to eliminate this delusional quality from dynamic models of oligopoly. Consider a typical duopoly scenario with two firms making repeated simultaneous quantity determinations. Friedman more commonly discusses price setting models, but these are straightforwardly analogous. Each firm believes that the other firm's behavior is determined only by the quantity pair selected in the previous period. In Friedman's work, as distinct from Cournot's, these beliefs are ultimately required to be consistent with the other firm's actual behavior. For example, firm 2 believes that firm l's output in the current period is given as

Price setting in Indian industry

Price setting models with variable mark-up rates are specified and estimated for four sectors of Indian industry. It is found that capacity utilisation has a significant effect on mark-up rates implying a Phillips curve type trade-off between output and prices. International prices do not appear to be as important in the price-setting behaviour of firms.