This is basically a co-sign on Nick Rowe, but in the terms I am used to.
Arnold Kling asks
If I have this right (and the main reason I am writing this post is to get feedback on whether I have this right), then this is a bit different from the Scott Sumner mechanism. In Rowe’s world, when the money supply contracts, producers are caught temporarily off guard and prices stay too high. This reduces M/P, leading to lower spending and output. In Sumner’s world, when the money supply contracts, price-setters read the situation clearly but nominal wages are sticky. Nominal GDP falls relative to nominal wages, and output contracts.
The issue with sticky wages is that they imply when prices rises real wages should fall, but they don’t they rise.
The mechanism that I am used to is that its not just that producers are caught of guard but that they face costs in changing prices. These might be literal menu costs. It might be that part of the benefit of lowering prices goes to producers of substitutes.
I tend to think that stable prices contribute to maintaining monopoly power. I am thinking of course of a monopolistic competition model. One in which there are lots of differentiated products. Consumers face a cost in deciding which product is best for them given all of the relative prices. If a producer changes his or her prices its harder for the consumer to perform this analysis. Thus consumers shy away from differentiated products which change prices a lot.
In business I think people would say that if you move your prices a lot you are “commoditizing” your product. That is, people will start judging your product more based on its price rather than your perceived quality difference.
Since its in the benefit of each profit maximizing company to hold its prices still but doing so hurts the general equilibrium there is an externality associated with unexpected price changes. This externality is why government intervention can improve the market result.
Now to me this all seems like the basic New Keynesian story and indeed its more or less how Greg Mankiw explains it on the EconLib website.
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Monday ~ January 31st, 2011 at 1:10 am
jsalvati
“… goes to the producers of substitutes” : did you mean complements?
More generally, I think it really would be something like “… goes to producers of goods with income elasticities larger than 0″. Producers cut prices which makes consumers money able to buy more goods, they respond by buying more of goods in general, not only the good who’s price was lowered.
Monday ~ January 31st, 2011 at 7:01 am
White Rabbit
“Consumers face a cost in deciding which product is best for them given all of the relative prices. If a producer changes his or her prices its harder for the consumer to perform this analysis. Thus consumers shy away from differentiated products which change prices a lot.”
Not really. Producers face:
– menu costs
– midlevel management SYA pressure to not fiddle with pricing
The menu costs can be non-trivial. The SYA pressure is significant as well: if the price change is only marginal do you *really* want to be the manager who last fiddled with the pricing model before revenue fell through the bottom?
So in practice decisions that change pricing go up to the highest level of management – which makes those decisions inflexible and inefficient.
There are a few exceptions for really volatile products like gas or food, there businesses have implemented technology to have flexible pricing – but for most other more complex things prices are pretty sticky – and especially so in recessions.
So in practice it’s typical that mostly only new products get new (wholesale) prices (and the old models get a fire-sale reduction until stock runs out) – and if the economy is in a slump then the frequency of new products decreases – further magnifying price stickiness.
So prices are sticky for multiple reasons – and the customer is the least of the reasons. Consumers have multiple choices anyway – manufacturer pricing and the set of features is rarely identical.
Monday ~ January 31st, 2011 at 7:19 am
White Rabbit
Addendum: there’s also the matter of trust.
For most bigger companies mid or low level management is simply not trusted with pricing decisions – as it’s a breeding ground for conflict of interest and corruption/fraud.
If you make $300k a year and have the power to flexibly negotiate $20m worth of inventory with a big customer.
Will you be a tough negotiator who settles for $20m or will you cut the price to $19m, where the customer will happily allow you to keep $250k of the proceeds in a private side-deal?
That temptation is real, as documented in real life again and again – even at the very best paid positions at the very best US companies (let alone in other countries where the level of corruption is higher).
So in practice most pricing models are rather rigid and negotiations are not particularly flexible either – and have to be signed off by higher management.
Pricing can only be flexible where the physical properties of the product are such that the product’s price is very directly coupled to the price of a resource (gas, food, energy).
The moment there’s product complexity and discretion involved, the moment the product’s shelf life-time is longer, pricing gets less and less flexible.
So in addition to monopolies, menu costs and SYA psychology the lack of trust in intermediaries/agents contributes to price stickiness as well.
Monday ~ January 31st, 2011 at 7:45 am
White Rabbit
At the risk of monopolizing this discussion
, there’s a sixth factor as well: whether a product’s market has an efficient auction mechanism.
In markets where products are highly standardized, either by their nature (natural resources/commodities), or by government fiat, auctions work rather well, both formally and informally: customers, small and large alike, can easily compare similar products and make decisions on price and allow competition take place.
For complex products manufacturers ‘differentiate’ to keep their products from being efficiently auctioned: they use various tactics to make it harder for customers to be able to compare prices. Because the moment customers can compare prices, the producer’s margins get squeezed …
So in our world the ‘free markets’ are a cat and mouse game between consumers hunting for the best deal and producers doing their best to keep consumers from finding the best deal …
One of the unintended consequences are monopolies or even in competitive markets widespread price discovery inefficiencies and general price rigidity.
And one of the unintended consequences of that is that in recessions demand controls the marketplace, not supply …