Friday, November 22, 2013

Downwards Rigidity of Prices and Mark-up Pricing

Empirical studies show that prices in modern market economies tend to be more flexible upwards than downwards when costs change (Peltzman 2000; Fabiani et al. 2007: 46, 49; Blinder et al. 1998: 156). That is, there is marked downwards rigidity in prices.

The explanation most probably lies in the administered price sector. It is clear that administered prices can remain stable or move in any direction in any phase of the business cycle (Lee 1998: 214).

Administered price firms that can avoid it, when they face no strong competitive pressures, such as through radical technology changes or productivity growth, simply prefer not to reduce their prices when factor input prices decrease, because the ability to increase sales from price reductions can be uncertain and the price reductions could reduce profits, as Lee points out:
“Where reported … business enterprises stated that variations in their prices within practical limits, given the prices of their competitors, produced virtually no change in their sales, and that variations in the market price, especially downward, produced little if any changes in market sales in the short term. Moreover, when the price change is significant enough to result in a non-insignificant change in sales, the impact on profits has been sufficiently negative to persuade enterprises not to try the experiment again.” (Lee 1998: 207).
One important reason for the tendency for prices to rise over time is most likely that many businesses will increase the profit mark-up and maintain prices when costs fall: there is a strong tendency for inflation, rather than deflation (Lee 2013: 475, citing Álvarez et al. 2006; Blinder et al. 1998; Fabiani et al. 2007).

This can be seen even in recessions since 1945 which are generally disinflationary – but disinflation is still a form of general rising prices, albeit at a lower rate than in previous years.

Thus the sources of modern price inflation are far more complicated than morality tales about reckless money supply growth or demand-side inflation explanations that rely on prices actually responding rapidly to supply and demand factors – when many mark-up prices simply do not adjust in this way.

Álvarez, Luis J., Dhyne, Emmanuel, Hoeberichts, Marco, Kwapil, Claudia, Le Bihan, Hervé, Lünnemann, Patrick, Martins, Fernando, Sabbatini, Roberto, Stahl, Harald, Vermeulen, Philip and Jouko Vilmunen. 2006. “Sticky Prices in the Euro Area: A Summary of New Micro-evidence,” Journal of the European Economic Association 4.2/3: 575–584.

Blinder, A. S. et al. (eds.). 1998. Asking about Prices: A New Approach to Understanding Price Stickiness. Russell Sage Foundation, New York.

Fabiani, Silvia, Suzanne Loupias, Claire, Monteiro Martins, Fernando Manuel and Roberto Sabbatini. 2007. Pricing Decisions in the Euro Area: How Firms set Prices and Why. Oxford University Press, New York.

Lee, Frederic S. 1998. Post Keynesian Price Theory. Cambridge University Press, Cambridge and New York.

Lee, Frederic S. 2013. “Post-Keynesian Price Theory: From Pricing to Market Governance to the Economy as a Whole,” in G. C. Harcourt and Peter Kriesler (eds.), The Oxford Handbook of Post-Keynesian Economics. Volume 1: Theory and Origins. Oxford University Press, Oxford and New York. 467–484.

Peltzman, Sam. 2000. “Prices Rise Faster than They Fall,” Journal of Political Economy 108.3: 466–502.

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