Price Setting and Price Stickiness: A Behavioral Foundation of Inaction Bands

This paper puts forward a behavioral theory of price setting where managers maximize perceived profits following a process of mental accounting. The theory predicts a pricing rule that is similar to—but crucially different from—that of a standard menu-cost theory: There is an inaction band, but there are two rather than just one target prices, depending on whether the firm updates its price upwards or downwards. The calibrated model replicates two patterns of price microdata that standard menu-cost models have difficulty accounting for: (i) the distribution of price changes has both small and large price changes and (ii) the hazard function of price changes is downward sloping initially, that is, firms that have just recently changed their price have a higher probability of changing it again, while this probability becomes constant thereafter.