Firm-to-Firm Relationships and Price Rigidity: Theory and Evidence

Economists have long suspected that firm-to-firm relationships might increase price rigidity due to the use of explicit or implicit fixed-price contracts. Using transaction-level import data from the U.S. Census, I study the responsiveness of prices to exchange rate changes and show that prices are in fact substantially more responsive to these cost shocks in older versus newly formed relationships. Based on additional stylized facts about price setting and trading volumes throughout a relationship's life cycle, I develop a model of relationship dynamics in which a buyer and a seller interact repeatedly under limited commitment and accumulate relationship capital in proportion to sales to lower production costs. In a new relationship, capital is low, and the seller responds little to shocks and sets low mark-ups to incentivize the buyer to maintain the association and to build up relationship capital. These motives are weaker in old relationships, which on average have more capital, increasing the price response to shocks and raising mark-ups. Once structurally estimated, the model generates countercyclical mark-ups and countercyclical pass-through of shocks through variation in the economy's average relationship length, which rises in recessions.