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Price Setting in a Forward-Looking Customer Market

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Author Info
Emi Nakamura (Harvard University)
Jon Steinsson (Harvard University)

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Abstract

We propose a new explanation for price rigidity. We show that if consumers form habits in individual goods, then firms face a time- inconsistency problem. The consumers’ habits imply that low prices in the future help attract customers in the present. Firms would therefore like to promise low prices in the future. But when the future arrives they have an incentive to exploit consumers’ habits and price gouge. In this model, unlike the standard no-habit model, nominal price rigidity is an equilibrium outcome. Equilibrium price rigidity can be sustained because rigid prices help firms overcome the time-inconsistency problem. If customers have incomplete information about firms’ desired prices, the optimal policy for the firm is to commit to a “price cap”. Our model therefore provides an explanation for the simultaneous existence of a rigid regular price and frequent sales, a pattern that is difficult to reconcile with existing menu cost models or price rigidity. Our model also explains survey evidence on firms’ fears of adverse customer reactions to price changes, the fact that firms make open commitments to customers not to change their prices, the tendency of price rigidity to increase with the frequency of repeat purchases and the tendency of prices to be more rigid to existing customers than new customers.

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Paper provided by EconWPA in its series Macroeconomics with number 0509010.

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Length: 54 pages
Date of creation: 05 Sep 2005
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Handle: RePEc:wpa:wuwpma:0509010

Note: Type of Document - pdf; pages: 54
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Related research
Keywords: Time-inconsistency; Price Rigidity; Habit Formation; Asymmetric Information.;

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Find related papers by JEL classification:
E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

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  4. John Y. Campbell & John H. Cochrane, 1994. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," CRSP working papers 412, Center for Research in Security Prices, Graduate School of Business, University of Chicago. [Downloadable!]
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  21. Apel, Mikael & Friberg, Richard & Hallsten, Kerstin, 2001. "Micro Foundations of Macroeconomic Price Adjustment: Survey Evidence from Swedish Firms," Working Paper Series 128, Sveriges Riksbank (Central Bank of Sweden). [Downloadable!]
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Isaac Kleshchelski & Nicolas Vincent, 2007. "Market Share and Price Rigidity," Cahiers de recherche 08-01, HEC Montréal, Institut d'économie appliquée. [Downloadable!]
  2. David M. Arseneau & Sanjay K. Chugh, 2007. "Bargaining, fairness, and price rigidity in a DSGE environment," International Finance Discussion Papers 900, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  3. George A. Akerlof, 2007. "The Missing Motivation in Macroeconomics," American Economic Review, American Economic Association, vol. 97(1), pages 5-36, March. [Downloadable!]
  4. David M. Arseneau & Sanjay K. Chugh, 2008. "Optimal fiscal and monetary policy in customer markets," International Finance Discussion Papers 919, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  5. Peter Berck & Jennifer Brown & Jeffrey Perloff & Sofia Villas-Boas, 2007. "Sales: Tests of Theories on Causality and Timing," Department of Agricultural & Resource Economics, UC Berkeley, Working Paper Series 1031, Department of Agricultural & Resource Economics, UC Berkeley. [Downloadable!]
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