Paralyzed by Fear: Rigid and Discrete Pricing under Demand Uncertainty

Price rigidity is central to many predictions of modern macroeconomic models, yet, standard models are at odds with certain robust empirical facts from micro price datasets. We propose a new, parsimonious theory of price rigidity, built around the idea of demand uncertainty, that is consistent with...

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Bibliographic Details
Published inNBER Working Paper Series p. 22490
Main Authors Ilut, Cosmin L, Rosen Valchev, Vincent, Nicolas
Format Paper
LanguageEnglish
Published Cambridge National Bureau of Economic Research, Inc 01.08.2016
Subjects
Competition
Demand
Economic models
Economic statistics
Economic theory
Macroeconomics
Monopolistic competition
Price cuts
Prices
Pricing policies
Studies
Uncertainty
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Summary:Price rigidity is central to many predictions of modern macroeconomic models, yet, standard models are at odds with certain robust empirical facts from micro price datasets. We propose a new, parsimonious theory of price rigidity, built around the idea of demand uncertainty, that is consistent with a number of salient micro facts. In the model, the monopolistic firm faces Knightian uncertainty about its competitive environment, which has two key implications. First, the firm is uncertain about the shape of its demand function, and learns about it from past observations of quantities sold. This leads to kinks in the expected profit function at previously observed prices, which act as endogenous costs of changing prices and generate price stickiness and a discrete price distribution. Second, the firm is uncertain about how aggregate prices relate to the prices of its direct competitors, and the resulting robust pricing decision makes our rigidity nominal in nature.
ISSN:0898-2937
DOI:10.3386/w22490