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Price Setting in a Forward-Looking Customer Market

  • Emi Nakamura

    (Harvard University)

  • Jon Steinsson

    (Harvard University)

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
Date of revision:
Handle: RePEc:wpa:wuwpma:0509010
Note: Type of Document - pdf; pages: 54
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