Asking About Prices

Asking About Prices: A New Approach to Understanding Price Stickiness

Alan S. Blinder
Elie R. D. Canetti
David E. Lebow
Jeremy B. Rudd
Copyright Date: 1998
Published by: Russell Sage Foundation
Pages: 336
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  • Book Info
    Asking About Prices
    Book Description:

    Why do consumer prices and wages adjust so slowly to changes in market conditions? The rigidity or stickiness of price setting in business is central to Keynesian economic theory and a key to understanding how monetary policy works, yet economists have made little headway in determining why it occurs. Asking About Prices offers a groundbreaking empirical approach to a puzzle for which theories abound but facts are scarce. Leading economist Alan Blinder, along with co-authors Elie Canetti, David Lebow, and Jeremy B. Rudd, interviewed a national, multi-industry sample of 200 CEOs, company heads, and other corporate price setters to test the validity of twelve prominent theories of price stickiness. Using everyday language and pertinent scenarios, the carefully designed survey asked decisionmakers how prominently these theoretical concerns entered into their own attitudes and thought processes. Do businesses tend to view the costs of changing prices as prohibitive? Do they worry that lower prices will be equated with poorer quality goods? Are firms more likely to try alternate strategies to changing prices, such as warehousing excess inventory or improving their quality of service? To what extent are prices held in place by contractual agreements, or by invisible handshakes? Asking About Prices offers a gold mine of previously unavailable information. It affirms the widespread presence of price stickiness in American industry, and offers the only available guide to such business details as what fraction of goods are sold by fixed price contract, how often transactions involve repeat customers, and how and when firms review their prices. Some results are surprising: contrary to popular wisdom, prices do not increase more easily than they decrease, and firms do not appear to practice anticipatory pricing, even when they can foresee cost increases. Asking About Prices also offers a chapter-by-chapter review of the survey findings for each of the twelve theories of price stickiness. The authors determine which theories are most popular with actual price setters, how practices vary within different business sectors, across firms of different sizes, and so on. They also direct economists' attention toward a rationale for price stickiness that does not stem from conventional theory, namely a strong reluctance by firms to antagonize or inconvenience their customers. By illuminating how company executives actually think about price setting, Asking About Prices provides an elegant model of a valuable new approach to conducting economic research.

    eISBN: 978-1-61044-068-4
    Subjects: Economics

Table of Contents

  1. Front Matter
    (pp. i-vi)
  2. Table of Contents
    (pp. vii-x)
  3. Preface
    (pp. xi-xiv)
    Alan S. Blinder
    • Chapter 1 Why Study Price Stickiness? Why This Way?
      (pp. 3-15)

      In recent decades, macroeconomic theorists have devoted enormous amounts of time, thought, and energy to the search for better microtheoretic foundations for macroeconomic behavior. Nowhere has this search borne less fruit than in seeking answers to the following question: Why do nominal wages and prices react so slowly to business cycle developments? In short, why are wages and prices so “sticky”? The abject failure of the standard research methodology to make headway on this critical issue in the microfoundations of macroeconomics motivated the unorthodox approach of the present study.

      No one should think the question unimportant. On the contrary, sticky...

    • Chapter 2 Antecedents
      (pp. 16-46)

      This chapter offers a highly selective summary of previous research on price stickiness. The intent is not to provide a comprehensive survey of all the relevant literature; in particular, scant attention is paid to the mountains of empirical work that support the view that prices are in fact sticky. Rather, the chapter is meant to provide context for the interview study and, to some extent, to justify its form.

      The next section presents a fairly complete catalogue of theories of sticky prices, paying careful attention (wherever possible) to the empirical evidence bearing on each. Readers who are already thoroughly conversant...

    • Chapter 3 Research Design
      (pp. 47-80)

      It is a troublesome truism of survey research that the details of how you ask a question, and to whom, exert a powerful influence on the answers you get. So we take pains in this chapter to spell out precisely how the survey was designed and conducted. Providing such details is particularly important when the survey methodology is as novel as this one’s was. To our knowledge, there have been no previous attempts to survey a random sample of the GDP.¹ One of the first things you learn in attempting to do so is that surveying the GDP is quite...

    • Chapter 4 Wouldn’t It Be Nice to Know . . . ? The Factual Basis for Theories of Price Stickiness
      (pp. 83-106)

      This study was motivated by the belief that theories of price rigidity were being generated in an empirical vacuum, insufficiently informed by the facts. What share of United States GDP is sold under nominal contracts? For how long do those contracts normally fix prices? How many firms encounter significant “menu costs” or other costs of adjusting prices? How common is judging quality by price? The list of what we do not know about price stickiness could go on and on.

      The list of what we do know is distressingly short.¹ The huge number of times that Stephen Cecchetti’s (1986) paper...

    • Chapter 5 Basic Results on the Twelve Theories
      (pp. 107-126)

      The main objective of the survey was not to compile the unadorned facts that were examined in chapter 4, fascinating as they may be. Rather, the study was designed to gather the opinions of real-world decision makers on the validity of economists’ theories of price stickiness. It is to these central results that we now turn. This chapter focuses on broad-brush findings that cut across the twelve theories. Which theories are most “popular” with actual price setters? Which theories are correlated with which? Are prices more sticky downward than upward?

      The following twelve chapters then delve more deeply into the...

    • Chapter 6 Nominal Contracting
      (pp. 129-148)

      This is the first in a series of twelve short chapters examining the theories one by one. We begin with the simplest imaginable explanation of price stickiness, which posits the existence of nominal contracts that set prices in advance. If such contracts cover any substantial share of GDP and last for nontrivial periods of time, they obviously impart some inertia to the aggregate price level.

      Some economists would argue that this idea is not a “theory” at all, for it fails to explain why parties enter into such contracts in the first place. We have no quarrel with this epistemological...

    • Chapter 7 Implicit Contracts
      (pp. 149-164)

      The implicit contract theory was originated by Costas Azariadis (1975), Martin Baily (1974), and Donald Gordon (1974) to explain wage rigidity. Their idea was that risk-neutral firms provide a form of insurance to their risk-averse workers by stabilizing wages in the face of fluctuations in, say, product demand. This, they argued, leads to an equilibrium (implicit) contract in which employment varies over the cycle while wages remain constant. Because this contract is a risk-sharing arrangement based on optimizing behavior, it must—according to the dictates of neoclassical theory—apply to real rather than to nominal wages.

      A few years later,...

    • Chapter 8 Judging Quality by Price
      (pp. 165-174)

      During the 1970s and 1980s, economic theorists increasingly turned their attention to the problems raised by imperfect information in markets and, in particular, to asymmetrically imperfect information—cases in which one party to a transaction is better informed than the other. Literally hundreds of papers were written exploring the implications of two phenomena that potentially bedevil such markets: adverse selection and moral hazard. It is only a slight exaggeration to say that the rulebook of economic theory was substantially rewritten in the process. Joseph Stiglitz (1987), for example, referred to the “repeal” of the law of supply and demand.


    • Chapter 9 Psychological Pricing Points
      (pp. 175-185)

      The next theory tested in the survey did not emerge from the economic literature at all. It has its roots, instead, in the folklore of marketing and seems more closely related to psychologists’ concept of “salience” than to economists’ models of optimizing behavior.¹ The idea is that certain prices—such as round numbers—have such psychological significance to consumers that they form a kind of barrier against price increases. So prices get “stuck” at numbers like $9.99 or $29.95, rather than move up to, say, $10.32 or $31.43. Such barriers can be breached, of course; but it takes more than...

    • Chapter 10 Procyclical Elasticity of Demand
      (pp. 186-196)

      According to the most naive view of the cyclical behavior of prices, marginal cost is an increasing function of output and price is equal to marginal cost. Hence prices should be procyclical, as indicated in a supply-demand diagram for a typical industry (see figure 10.1). In a sense, the entire literature on sticky prices revolves around explaining where and why this naive view goes wrong.

      One important class of explanations focuses on countercyclical markups of price over marginal cost. The naive view implicitly assumes constant markups; hence procyclical marginal cost (MC) gets translated directly into procyclical price (P). But suppose...

    • Chapter 11 Cost-Based Pricing: Lags from the Chain of Production
      (pp. 197-210)

      That prices depend on costs hardly qualifies as a new idea. Nor does it, by itself, constitute a theory of price rigidity. It simply says that prices are sticky if costs—presumably marginal costs—are. Since costs primarily depend on other prices (including wages), this statement borders on the tautological: some prices are sticky because others are. Indeed, it has been well known for decades that Keynesian (nominal) rigidity can be rooted inwagestickiness, with prices responding rapidly to wages. However, this book is devoted to theories ofpricestickiness, not wage stickiness.

      What takes the theory that prices...

    • Chapter 12 Constant Marginal Cost
      (pp. 211-225)

      One simple theory of price rigidity begins by expressing the price of some representative firm in the following cumbersome way:$\caption12.1\quad \rm{P}=\left ( \frac{\rm{P}}{\rm{MR}} \right )\left ( \frac{\rm{MR}}{\rm{MC}} \right )\rm{MC}$

      As we have remarked before, it is well known that the ratio of price to marginal revenue is a decreasing function of the elasticity of demand, as in the following equation:$\caption12.2\quad \frac{\rm{P}}{\rm{MR}}=\frac{\epsilon}{\epsilon-1}=\rm{f}(\epsilon)$,

      and that profit maximization sets the middle term in 12.1 equal to unity. Hence:$\caption12.3\quad \rm{P}=\rm{f}(\epsilon)\rm{MC}$

      So, if marginal cost and the elasticity of demand are both approximately constant over the business cycle, then P will be constant, too.

      Notice several things about this apparently trivial result....

    • Chapter 13 Costs of Adjusting Prices
      (pp. 226-252)

      Among the simpler reasons why prices might be sticky is the idea that it is costly for firms to change their prices. Clearly, a profit-maximizing firm facing such adjustment costs will change its prices less often than an otherwise identical firm without such costs.

      Adjustment costs for prices are typically modeled in one of two ways. In the first variant, adjustment costs are convex and, where explicit solutions are needed, quadratic. The best-known example is by the economist Julio Rotemberg (1982). In his model, firms minimize the expected discounted present value of:


      Here$\rm{p}_{\rm{t}}^{\ast}$is the price that equates...

    • Chapter 14 Hierarchy
      (pp. 253-259)

      The hierarchy theory attributes price stickiness to delays in getting a large, hierarchical organization to act. If many people are required to “sign off” on a price change, prices may be incapable of changing rapidly in response to changes in the firm’s environment.

      This theory is the only one of the twelve examined in this book that was not culled from the economic literature. Rather, it was suggested by a businessman. As noted in chapter 3, six executives volunteered to help us pretest the questionnaire. At the end of each of these six interviews, we asked whether we had omitted...

    • Chapter 15 Coordination Failure
      (pp. 260-273)

      According to the coordination failure theory, price setting involves an important element of “following the crowd” Suppose demand in a particular industry rises, warranting an increase in relative price. An individual firm in that industry will certainly want to raise its price if it thinks that other firms are going to raise theirs. And other firms might feel the same way. But each firm worries that its competitors might not raise their prices; so each waits for the others to move first. Absent an effective coordinating mechanism that would enable all the firms in the industry to move in concert,...

    • Chapter 16 Inventories
      (pp. 274-282)

      Many sellers of goods—but not of services—hold finished goods in inventory. Economists have long viewed such inventories as buffer stocks which firms can and do use to smooth fluctuations in production relative to those in sales. The presumed reason is that cost curves are convex—which implies that it is costly to vary output. So, although the term is rarely used in this context, inventories make output “stickier” than underlying demand.

      In the early 1980s, several authors—notably Patricia Reagan (1982) and Alan Blinder (1982)—observed that a similar argument can be made about prices. The basic idea...

    • Chapter 17 Nonprice Competition
      (pp. 283-292)

      It is no accident that this book focuses exclusively on price behavior. Economists generally look upon prices as the principal vehicle used to clear markets and to allocate resources. In many conceptually simple—though perhaps technically dense—expositions of the theoretical virtues of the market mechanism, it is said that the market price embodies everything that buyers and sellers need to know about the commodity in question. That is quite a sweeping claim, once you stop to think about it.

      But several authors, most notably Dennis Carlton (1989), have argued that markets may clear along dimensions other than price. A...

    • Chapter 18 What Have We Learned?
      (pp. 295-314)

      Part III, one chapter for each theory, was tightly focused on the trees. It is now time to draw up a map of the forest—to put the research results into some perspective. In this concluding chapter, we highlight some things we have learned and mention some things we have not learned. We ask whether the highly unorthodox interview methodology delivered on its promises, and how it might be improved. Most important, we examine how the findings should change economists’ views on price stickiness in the U.S. economy: What are the basic lessons for macroeconomics—or, for that matter, for...

  8. Appendix A Manufacturing Interview
    (pp. 315-336)
  9. Appendix B List of Variable Names
    (pp. 337-338)
  10. Notes
    (pp. 339-360)
  11. Bibliography
    (pp. 361-370)
  12. Index
    (pp. 371-386)