Price Updating with Production Networks

Firms do not completely pass through their cost shocks onto output prices, generating variable markups that attenuate price movements across firms. While the impact of partial cost shocks such as exchange rate volatility are well-documented, much less is known about general cost pass-through at the micro level, and its implications for aggregate outcomes such as inflation. We develop a non-parametric framework of how producers update prices. Our structural elasticities allow for heterogeneity in price changes and the relationship between buyers and suppliers in a production network. The framework is consistent with various price setting mechanisms, and does not impose a particular market structure or demand functional form. Exploiting rich data on producer prices and the network structure of production in Belgium, we find that on average, input price pass-through is incomplete and very much below one, while firms also strongly react to other prices in their environment. Next, we study the propagation and aggregation properties of incomplete pass-through. A shock of 10% to firms’ import prices generates a change in the producer price index of only 2.5%, reducing the initial cost shock by 75%, or less than half of what is predicted by models with complete pass-through. This result might provide an alternative explanation to the exchange rate disconnect puzzle under flexible prices.