A Kinked-Demand Theory of Price Rigidity

I provide a microfounded theory for one of the oldest, but so far informal, explanations of price rigidity: the kinked demand curve theory. Assuming that some customers observe at no cost only the price of the store they happen to be at gives rise to a kink in firms' demand curves: a price increase above the market price repels more customers than a price decrease attracts. The kink in turn makes a range of prices consistent with equilibrium, but a selection criterion that captures firms' reluctance to be the first to change prices---the adaptive rational-expectations criterion---selects a unique equilibrium where prices stay constant for a long time. The kinked-demand theory is consistent with price-setters' account of price rigidity as arising from the customer's---not the firm's---side, and their account of their reluctance to make the first step in changing prices. The kinked-demand theory can be tested against menu-cost models in micro data: it predicts that prices should be more likely to change if they have recently changed, and that prices should be more flexible in markets where customers can more easily compare prices. At the macro level, the kinked-demand theory induces a trade-off between output and inflation that substantially differs from prominent theories of sticky prices: the Phillips curve is strongly convex but does not contain any (present or past) expectations of inflation, and is non-vertical in the long-run.