What is current in price theory...

I second this call from Robert Vienneau.  Where can one find the canonical statement of a current theory of prices?

Some of friends of mine are keen to form a price theory discussion group when I get back to Edinburgh, and I suspect that they are going to focus on more mainstream (i.e., Arrow-Debreu style) price theory.  I would like to contribute something as an alternative...but what?

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 summarize...as 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...  

Asking About Prices...

I have finished reading Alan Blinder's "Asking About Prices." I would highly recommend it. Among the many survey results he reports I will mention several that stuck out for me in particular:

1. The majority of firms surveyed reported that they had globally declining MC curves (as opposed to the textbook increasing marginal costs). Blinder does point out that marginal costs is not a concept that makes much sense to real world businessmen and posits that they may be confounding MC with AC.
2. Hardly any firms used freely available data on inflation as part of their price setting decisions...hard to justify unless you allow for the possibility that people suffer from money illusion.
3. The theory of sticky prices that tested the best (by far) amongst real world businessmen was a theory of coordination failure amongst firms (2nd best was a theory of NON-price adjustment where markets clear in dimensions other than price). Without going into the bowels of the coordination failure theory it is worth noting that this theory predicts a priori that prices should be more sticky when prices are increasing. This is counter to the conventional Keynesian idea that prices are sticky when they are decreasing. This is particularly noteworthy in light of another major survey finding...
4. Survey finds evidence that prices are more sticky when prices are increasing than when prices are decreasing! One key reason for this that crept up again and again in the free form answers from real world businessmen was that they were afraid to increase prices because they did not want to "antagonize their customers." This idea has a very Keynesian "Animal Spirits" flavor to it...

I could go on with additional nuggets...but really anyone interested in macro should read the book.