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Price Dynamics with Customer Markets

  • Luigi Paciello

    (EIEF and CEPR)

  • Andrea Pozzi

    (EIEF and CEPR)

  • Nicholas Trachter

    (Federal Reserve Bank of Richmond)

The customer base of a firm is an important and persistent determinant of its performance. We show that the interaction between firm pricing and customer dynamics affects the determination of price markups in response to idiosyncratic and aggregate shocks, and that such interaction varies with the cycle. We study an economy where the customer base of a firm is persistent because of search frictions preventing customers from freely relocating across suppliers of consumption goods. The key feature of our model is that the elasticity of the customer base to price - the extensive margin elasticity of demand - depends on the customers’ endogenous opportunity cost of search. This results into a new channel affecting the cyclical relationship between consumer search, markups and price dispersion. In particular, an increase in the marginal utility of consumption increases customers’ incentives to search resulting in higher demand elasticity and lower markups and price dispersion. To analyze the quantitative implications of customer markets, we calibrate the search friction using rich U.S. data on consumer shopping behavior and good prices. The estimated model predicts a procyclical response of search and a countercyclical response of markups to aggregate demand shocks amplifying their effect on output.

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Paper provided by Einaudi Institute for Economics and Finance (EIEF) in its series EIEF Working Papers Series with number 1328.

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Length: 63 pages
Date of creation: 2013
Date of revision: Dec 2015
Handle: RePEc:eie:wpaper:1328
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