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Friday, July 23, 2010

Asking About Prices, Again...

Due to popular demand, I thought that I would take some time to expound upon some of the interesting results from Alan Blinder's Asking About Prices: A New Approach to Understanding Price Stickiness.

First of all, why should we care about price stickiness?  Chiefly because sluggish price adjustment (price stickiness) provides a mechanism through which monetary policy can affect the real economy.

The following theories of prices stickiness emerged from the results of Blinder's survey as winners: coordination failure, non-price competition, implicit contracts and cost-based pricing (it is worth noting that all of the theories that did well in the survey have a distinctly Keynesian flavor):
  1. Coordination Failure: Firms hold back on price changes waiting for other firms to go first.
  2. Cost-Based Pricing: Price rises are delayed until costs rise, and these delays accumulate through  multi-stage production process.
  3. Non-Price Competition: Firms vary non-price elements such as delivery lags, service, or quality.
  4. Implicit Contracts: Firms tacitly agree to stabilize prices, perhaps out of "fairness" to customers.
Coordination Failure: First it is worth noting that this theory implies a priori that price increases should be "stickier" than price decreases.  This implication was borne out in the survey data.  As Blinder points out, the theory also implies that increases in the nominal money supply should be more effective at ending recessions than decreases in the nominal money supply are at causing them.  

Non-Price Competition: This one is a bit more difficult to such I will try to address it in a later blog post.

Implicit Contracts and Cost-Based Pricing: Though it did well in the survey, Okun's implicit contract theory is difficult to test. Okun's original idea was that firms would form these implicit contracts as a result of their desire to attract repeat customers and thus economize on search costs.  Interestingly, firms in the survey with larger numbers of repeat customers did not rate this theory highly.  Firms who rated this theory highly focused on the need to establish a general reputation for "fairness" or "fair-dealing."  Now cost-based pricing only works as a theory of price stickiness if firms fail to react to anticipated increases in input prices (i.e., costs).  Why would a firm not raise nominal prices if it sees nominal cost rises coming?  Coordination failure and an unwillingness to antagonize customers perhaps (i.e., implicit contract theory)?  But what about money illusion?  Any implicit contracts that are optimal/rational would have to apply to relative prices (i.e. real prices).  Thus there should be no money illusion...but Blinder's survey results clearly demonstrate that firms rarely pay attention to national inflation forecasts.  Most real-world contracts are nominal.  How to reconcile these two facts...perhaps if firms believe that customers suffer from money illusion, then frequently tinkering with nominal prices as part of an effort to stabilize real/relative prices might drive them off!

I really enjoyed reading this book.  I think Blinder's contribution is significant and worthy of more notoriety than it seems to have attained.  In fact I wonder if you could use the book to teach a graduate course (or part of one) in macro...  


  1. Indeed, I wonder...

    (to be discussed in Scotland)

    And thanks for responding to the cracy of the demo.

    I look forward to future installments.

  2. There's been lots of recent interesting research on pricing, based on very disaggregated data, which I'm trying to read up on. Some good (and fairly standard) references would be
    Peltzman, 'Prices Rise Faster Than They Fall', JPE 2000
    Bils and Klenow 'Some Evidence on the Importance of Sticky Prices' JPE 2004
    Steinsson and Nakamura 'Five Facts About Prices' (the authors also have a paper on their website formalizing Okun's notion of implicit contracts)
    I can give further references if you're interested.

    Two findings stand out for me. One is that prices increase faster in response to cost increases than they decrease in response to cost decreases (most infamously in the case of gasoline prices). The other is that the vast majority of retail price changes are retailer-specific sales, i.e. large cuts in price that are soon reversed.

  3. Great references. Thanks, Keshav.

    But S&Ns 'Five Facts' suggests that sales are not the vast majority, but rather are almost exactly half of consumer price changes.

    Or do I misunderstand?

  4. You're right, I misspoke. I was thinking of a different (but related) finding in Nakamura's 'Passthrough in retail and wholesale', that only 16% of variation in prices at the 'Universal Product Code' level is common across stores selling an identical product - 65% is common to stores in a particular retail chain, and 17% is specific to the store and product. But even if most price changes are retailer-specific, not all retailer-specific price changes are sales, so my claim was incorrect.