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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Sprache: Englisch
The prices of some products fluctuate dramatically, while others remain more constant. What accounts for these extreme differences?
Renowned economist Truman F. Bewley investigates and elucidates this puzzling problem. Its crux, he argues, is that differentiated product prices are usually stable, whereas the prices of undifferentiated products – for which buyers can easily find comparable substitutes – are often volatile. Although product differentiation gives producers market power, this power alone does not guarantee price stability. There are nearly undifferentiated products whose producers have market power yet for which prices are unstable. Weakness of product differentiation makes it so advantageous for producers to compete on price that they do so and forego the benefits and stability of price collusion. Producers of truly differentiated goods prefer to compete on product performance rather than price and find that reducing prices during recessions does little to increase demand.
Based on hundreds of interviews with businesspeople responsible for setting prices, Bewley’s book is an unusual and groundbreaking work, with findings vital for economists, students, and policymakers.
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Veröffentlichungsjahr: 2025
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Table of Contents
Cover
Title Page
Copyright Page
Acknowledgments
1 Introduction
1.1 Rigidity of the Prices of Highly Differentiated Products
1.1.1 Macroeconomic Implications
1.1.2 Related Literature
1.2 The Behavior of Marginal and Average Variable Costs as a Function of Output
1.3 The Treatment of Fixed Costs by Manufacturers of Products that Are Not Commodities
1.4 The Treatment of Fixed Costs by Commodity Manufacturers
1.5 Formula-based Pricing
1.6 Organization of Commodity Pricing
1.7 Plan of the Book
1.8 Related Literature
Notes
2 The Pricing of Manufactured Goods
2.1 Methods for Pricing Highly Differentiated Products
2.2 Downward Rigidity of Highly Differentiated Product Prices
2.2.1 Incidence of Product Differentiation and of Explanations for Downward Price Rigidity of Highly Differentiated Products
2.2.2 Price Reductions of Highly Differentiated Products during Recessions Do Not Increase Sales Enough to be Profitable
2.2.3 Sellers of Highly Differentiated Products Do Not Want to Reduce Prices during Recessions because Reductions Are Hard to Reverse
2.2.4 It is Difficult in General to Increase the Prices of Highly Differentiated Products
2.2.5 Price Rigidity in the Major Household Appliance, Automobile, and Machine Tool Industries
Pricing of Major Household Appliances
Automobile Pricing
Pricing of Standardized Machine Tools
2.2.6 Reasons for Cutting the Prices of Highly Differentiated Products in Slow Times
2.2.7 Rigidity of the Prices of Flows of Inputs of Highly Differentiated Goods from One Manufacturing Firm to Another
2.2.8 Downward Price Rigidity of Value Priced Productive Inputs
2.2.9 Other Factors that Contribute to the Downward Price Rigidity of Highly Differentiated Products
2.2.10 Related Literature
2.3 The Price Stability of Two Types of Differentiated Goods
2.4 Effects of the Administrative Costs of Price Change
2.4.1 Related Literature
2.5 Evidence of Constant or Declining Average and Marginal Variable Costs
Lower Setup and Changeover Costs and Learning by Doing
Employees Work Harder When There Is More to Do
2.5.1 Electricity Generators
2.5.2 Related Literature
2.6 The Treatment of Fixed Costs and the Use of Fully Absorbing Cost Systems
2.6.1 The Uses of Full Absorption Cost Systems
2.6.2 Attitudes toward Fully Absorbing Cost Systems
2.6.3 Contribution Margin Pricing
2.6.4 Other Evidence that Fixed Expenses Can Affect Prices
2.6.5 The Need for Absorping Cost Systems
2.6.6 Development Costs of Products Sold to a Market
2.6.7 Development Costs of Custom Products
2.6.8 Related Literature
2.7 Formula-based Pricing
2.7.1 Market Risk
2.7.2 Price Indices
2.7.3 Why the Shift to Formula-based Prices?
2.7.4 Disadvantages of Formula-based Pricing
Notes
3 Retail Pricing
3.1 The Role of the Wholesaler
3.2 Retail Price Setting
3.2.1 Related Literature
3.3 Commodities and Highly Differentiated Goods in Retail Trade
3.4 The Retail Price Behavior of Lettuce
3.5 The Difficulty Grocers Have Controlling Commodity Prices
3.6 Holding Wholesale Commodity Prices Temporarily Fixed for Retail Promotions
3.7 The Use of Fixed and Formula-based Contracts in Retail Trade to Secure Supplies of Branded Products
3.8 Does Brand Alone Stabilize Price?
3.9 Retailer Resistance to Manufacturers’ Increases in the Prices of Highly Differentiated Goods
3.10 The Effect of Sellers’ Administrative Costs of Price Change
3.11 The Effect of Retail Buyers’ Administrative Costs of Price Change
3.12 The Impact of Recessions
Notes
4 Restaurant Pricing
4.1 Industry Competition
4.2 Franchisees’ Pricing Freedom
4.3 Pricing Tiers within Restaurant Chains
4.4 Labor Costs and Variable Costs
4.5 Food Costs and Pricing
4.6 Pricing and Fixed Costs
4.7 Specials
4.8 Importance of Repeat Customers
4.9 Price Change
4.10 Menu Costs and Price Change
4.11 Purchasing
4.12 Market Research
4.13 Impact of Recession
4.14 Price Behavior
Notes
5 Pricing by Contract Manufacturers
5.1 The Mechanics of Contract Manufacturing
5.2 Competition
5.3 The Choice of Bid
5.4 Contribution Margin Pricing
5.5 Reactions to Reduced Demand
Notes
6 Pricing in the Construction Industry
6.1 General Contracting
6.2 Construction Management
6.3 Subcontracting
6.4 Construction Material Dealers and Manufacturers
6.5 Downward Price Rigidity of Some Materials
Notes
7 The Pricing of Cement
7.1 Background
7.2 Pricing
7.3 Capacity Utilization
7.4 Price Behavior
Notes
8 The Pricing of Commodity Lumber, Plywood, and Oriented Strand Board
8.1 The Market for Logs
8.2 The Markets for Lumber, Plywood, and Oriented Strand Board
8.3 The Use of Market Reports
8.4 Capacity Utilization
8.5 Price Behavior
Notes
9 The Pricing of Midwestern Food and Feed Grains
9.1 Futures
9.2 Grain Pricing
9.2.1 Sale Prices of Grain
9.2.2 Hedging by Elevator Owners
9.2.3 Brokers
9.2.4 Farmers’ Marketing of Grain
9.2.5 Pricing of Flour and Hedging by Flourmills and Bakeries
9.2.6 Hedging by Soybean Crushing Plants
9.2.7 Price Behavior
Notes
10 Conclusion
Appendix
Example 1: Demand for a Single Input into Production
Example 2: Demand for a Consumption Good
Example 3: Futures Trading
References
Index
End User License Agreement
List of Tables
Chapter 2
Table 2.2.1
Table 2.2.2
Table 2.4.1
Table 2.5.1 The Effect of Increased Output on Average Variable Costs
Table 2.5.2
List of Illustrations
Chapter 2
Figure 2.3.1 Consumer Price Index for New Vehicles, Monthly Data, Not Seasonally Adjusted, Ja...
Figure 2.3.2 Total Vehicle Sales, Monthly Data, Seasonally Adjusted, January 1976–Dece...
Figure 2.3.3 Producer Price Index for Major Household Appliances, Monthly Data, Not Seasonall...
Figure 2.3.4 Industrial Production of Major Household Appliances, Monthly Data, Seasonally Ad...
Chapter 3
Figure 3.4.1 Retail Prices of Iceberg Lettuce in Dollars per Pound, Monthly Data, Not Seasona...
Figure 3.12.1 Total Grocery Store Sales, Monthly Data, Seasonally Adjusted, January 1992–...
Figure 3.12.2 Total Sales of Restaurants and Other Eating Places, Monthly Data, Not Seasonally...
Chapter 4
Figure 4.14.1 Consumer Price Index for Urban Consumers’ Meals away from Home, Monthly D...
Chapter 7
Figure 7.4.1 Producer Price Index for Cement, Monthly Data, Not Seasonally Adjusted, January ...
Figure 7.4.2 US Production Index of Cement, Monthly Data, Seasonally Adjusted, January 1972–...
Chapter 8
Figure 8.5.1 Producer Price Index for Softwood Lumber, Monthly Data, Not Seasonally Adjusted,...
Figure 8.5.2 Producer Price Index for Plywood, Monthly Data, Not Seasonally Adjusted, January...
Figure 8.5.3 Prices of Southern Pine 2x4s in Dollars per Thousand Board Feet, Weekly Data, Ju...
Chapter 9
Figure 9.2.1 Price Index for Wheat, Monthly Data, Not Seasonally Adjusted, January 1972–...
Figure 9.2.2 Producer Price Index for Wheat Flour, Monthly Data, Not Seasonally Adjusted, Jan...
Appendix
Figure A.1
Guide
Cover
Table of Contents
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Price Setting
Truman F. Bewley
polity
Copyright Page
Copyright © Truman F. Bewley 2025
The right of Truman F. Bewley to be identified as Author of this Work has been asserted in accordance with the UK Copyright, Designs and Patents Act 1988.
First published in 2025 by Polity Press
Polity Press
65 Bridge Street
Cambridge CB2 1UR, UK
Polity Press
111 River Street
Hoboken, NJ 07030, USA
All rights reserved. Except for the quotation of short passages for the purpose of criticism and review, no part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the publisher.
ISBN-13: 978-1-5095-6576-4
A catalogue record for this book is available from the British Library.
Library of Congress Control Number: 2024946664
by Fakenham Prepress Solutions, Fakenham, Norfolk NR21 8NL
The publisher has used its best endeavors to ensure that the URLs for external websites referred to in this book are correct and active at the time of going to press. However, the publisher has no responsibility for the websites and can make no guarantee that a site will remain live or that the content is or will remain appropriate.
Every effort has been made to trace all copyright holders, but if any have been overlooked the publisher will be pleased to include any necessary credits in any subsequent reprint or edition.
For further information on Polity, visit our website: politybooks.com
Acknowledgments
I gratefully acknowledge support from Sloan Foundation Grant B2000–69 and very generous support from the Cowles Foundation at Yale University. I owe a great deal to my colleague, Professor William Brainard, who did some of the interviews with me, helped arrange some of them, encouraged me, and spent a good deal of time reading and criticizing versions of the manuscript. His suggestions were invaluable. I am grateful to Professors Garry Brewer, James Robinson, and Timothy Guinnane for comments on the manuscript. I thank my research assistant Jorge Colmenares Miralles for his help with locating references. I am grateful to Michael Aronson for comments, advice, and encouragement. He was the editor of my book Why Wages Don’t Fall During a Recession, Cambridge, MA: Harvard University Press, 1999.
1Introduction
Why do the prices of some products fall little or even rise during business downturns while the prices of others fall dramatically and rebound during economic booms? It is not surprising that in highly competitive industries prices fluctuate with shifts in demand and supply, but what explains the dearth of price declines in markets where firms have more direct control of prices? This question is central to an understanding of business cycles. Although economists have proposed many explanations of downward price rigidity, no widely applicable theory has firm empirical support. Perhaps this is so because such support requires knowledge that is difficult to obtain, such as understanding the objectives of price setters and the constraints they face.
Hoping to find insight into price formation and rigidity, I imitated Alan Blinder and his coauthors (Blinder et al., 1998) by interviewing businesspeople who participate in price setting.1
Blinder and his associates used interviews to evaluate empirically twelve theories of price stickiness. The interviewers asked many questions, but their core approach was to describe each of the theories to respondents and ask them to assess its applicability to their company. On the basis of the answers, the authors rated on a numerical scale the importance of each theory as an explanation of price stickiness at that firm. The average of all the scores from all the interviews is a measure of the overall relevance of the theory. Blinder and his coauthors randomly chose the companies to be solicited for interviews, where the probability that a company was chosen was proportional to its value added.
Although I found the work of Blinder and his coauthors to be useful, I did not follow them by asking respondents to comment on the relevance of particular theories of price rigidity. Instead, when arranging interviews I explained that I hoped respondents would tell me what I needed to know to understand pricing in their company and industry. Before interviews, I emailed respondents a list of questions designed to make clear what topics interested me. During interviews, I used what respondents came up with as a basis for further questioning. A disadvantage of this approach was that not all respondents dealt with the same topics, so that the incidence of responses of a given type may not be a reliable gauge of its importance. Interpretation must rely on learning how respondents think, on the logic in the responses, and on circumstances described in them. An advantage of the approach is that I learned things I would not have thought to ask about. One reason I avoided the approach of Blinder and his coauthors is that economists may have overlooked correct theories of price rigidity. In fact, Blinder and his coauthors did not ask about the explanation of price rigidity that I found to be the most widely applicable.2 Another reason for not asking about theories is that in my experience such questions can cause respondents subtly to stop cooperating, if they think a theory is silly or if they feel they are being drawn into intellectual competition with a professor.
Because of my interviewing method, I could not select respondents randomly. Businesspeople are reluctant to participate in loosely structured interviews, because they worry that they might inadvertently reveal confidential information or say something that would embarrass their company. So, I had to gain trust, which I did by using what is called the snowball sampling method. I started by interviewing friends and acquaintances and, at the end of every interview, I asked for referrals to other possible respondents, while indicating what kinds of companies and people interested me. I promised full confidentiality to everyone I asked for interviews. This approach was for the most part successful, though slow. Sometimes, more than a year passed before a company’s lawyers agreed to let me interview in their firm. I had disappointments. For instance, I never penetrated the Internet commerce industry and I never had an interview with a plate-glass manufacturer. In requesting referrals, I sought variety in the types of businesses but also strove adequately to cover the main industries in the American economy and the most important companies within each. I did not record the number of interview requests that were refused, but believe I talked to key people in most of the categories of businesses I studied. Interviews usually took place in the respondent’s office, or in a restaurant, and lasted about ninety minutes. Most interviews were tape-recorded and later transcribed, though some respondents refused to be recorded. I checked for accuracy all the transcriptions that I did not do myself.
One might expect in a study like this to read about negative productivity shocks and Federal Reserve Bank inflation targeting or forward guidance, because these topics are much discussed in macroeconomics. Neither topic ever came up spontaneously, except when a few respondents mentioned the effects of drought on agriculture and of low water levels on river and lake shipping. I occasionally brought the topics up, but eventually desisted, because respondents implied they were irrelevant to pricing. They may have reacted this way regarding Federal Reserve Bank policy, because there was little inflation at the time.
I came up with three main findings, each of which is a phenomenon, together with explanations of why it occurs. The phenomenon in one finding is that the prices of highly differentiated products seldom decline and tend to increase only sluggishly in response to changes in demand or supply, whereas the prices of undifferentiated products respond so quickly to such shifts that many are volatile. By a highly differentiated product I mean one produced by only one firm and that is not a good substitute for any other product. A strong brand, for instance, makes a product highly differentiated.
The phenomenon in another main finding is that marginal variable costs of manufacturing firms tend to remain constant or to decline as a function of output until capacity is reached, at which point marginal variable costs rise abruptly. This assertion may seem counterintuitive, since, presumably, as output increases in the short-run more labor is used with a fixed amount of capital equipment. The proposition that marginal variable costs may be constant over a wide range of outputs is not new. For instance, Robert Hall suggests this idea (Hall, 1986), and Blinder and his coauthors present empirical evidence supporting it (Blinder et al., 1998, ch. 12).
The impact of declining or constant marginal variable costs on the ability of manufacturing firms to make money creates a link between the behavior of marginal variable costs and product differentiation. Firms with constant or declining marginal variable costs lose money if they set price equal to marginal variable cost, unless they produce at a level so close to capacity that marginal variable costs exceed average variable costs. This predicament no doubt helps explain the drive of many firms to differentiate their products, because differentiation normally enables firms to charge more than marginal variable cost and hence perhaps to cover fixed costs and earn a profit.
Constancy of marginal variable costs suggests an explanation of price stickiness that should be considered. The explanation is that if a product’s price equals a constant markup over marginal variable costs, then constancy of marginal variable costs implies price rigidity. The rigidity to be explained is the lack of response of price to the business cycle. If we assume that a firm’s marginal variable costs are roughly proportional to the average wages and salaries it pays, then it is reasonable to assume that nominal marginal variable costs do not fall during recessions, since economy-wide averages of nominal wages and salaries seldom fall.3 The proportionality between the price of labor and marginal variable costs is, however, questionable, since variable costs in manufacturing are often dominated by the costs of variable factors other than labor, costs that may have little to do with labor costs. The assumption that prices are a constant markup over marginal variable costs should also be questioned, because profit margins often decline during hard times. A weaker form of this assumption may be approximately valid, however, because many manufacturing firms set the price of each of their products to be roughly equal to a markup over the sum of average variable costs, and an assignment to the product of a share of the firm’s average overhead and fixed costs. Costs including this assignment are known as fully absorbing costs. If price is a markup over fully absorbing costs, then the markup of price over average variable costs is positive, even if no additional margin is added for profits. If we add the assumption that average variable costs are constant, then this line of thinking leads to a weak form of downward price rigidity; namely, that in a recession prices will not fall below some level that exceeds the constant level of average variable costs. This reasoning does not imply upward price rigidity, because wages and salaries are not upwardly rigid. A weakness of the theory is that some firms reduce the markup of price over average variable costs when demand slumps, by using what is called contribution margin pricing. A contribution margin price is one between average variable costs and fully absorbing costs.
The views of businesspeople do not support the attribution of downward price rigidity to cost-based pricing and constancy of marginal variable costs. None of my respondents came up with this idea as an explanation of price stickiness, and Blinder and his coauthors had a similar experience. Cost-based pricing, together with constant marginal variable costs, was one of the theories they asked about, and it did badly.4 My view is that though the mechanism described in the theory may contribute to downward price rigidity, much more information is needed to assess the mechanism’s importance.
The phenomenon in a third main finding is the widespread use of formula-based pricing in long-term contracts governing trade in commodities between firms, where, in business jargon, prices are “formula-based” if they are indexed to some publicly available statistics, and the word “commodity” refers to an undifferentiated product sold on a reasonably competitive market. I will use the words in these senses. By commodity, I do not mean something bought and sold, which is the normal usage in economics.
It should not be imagined that all products are either commodities or highly differentiated, since there are many degrees of differentiation. For instance, airline travel is somewhat differentiated and yet has fairly flexible pricing. The processes that create its prices have little in common with those generating the prices of commodities or of highly differentiated products. Most goods sold in stores seem to be either commodities or highly differentiated.
It is well known that most commodities have volatile prices. Respondents attributed the volatility to factors that varied with the product. Respondents said that supply fluctuations caused the prices of meat and fresh fruits and vegetables to be volatile. Extreme changes in the prices for natural gas and wholesale electricity were attributed to demand. Fluctuations in the prices of fresh fish and of petroleum and its products were said to be due to changes in both supply and demand. In discussions of the prices of lumber, commodity plywood, and oriented strand board, I heard about price-inventory cycles. When prices rise, expectations of further increases motivate market participants to buy and store products, driving prices higher. The reverse was said to occur when prices decline.
In most commodity markets, there is a volume of spot5 transactions between individual buyers and sellers who negotiate the prices. Because of the volatility of commodity prices, traders need guidance as to what to bid and ask. This need is filled by market-reporting companies, consulting companies, trade journals, and government agencies that make anonymous surveys of negotiated prices in specific markets and publish summaries of the findings. The negotiated prices surveyed are usually for spot transactions. The summaries of surveys by private organizations are available only to those who purchase them, and these sales pay for the surveys.
The published summaries not only guide traders, but form the basis for formula-based prices. The formulas specify prices as mathematical functions of survey results. The formulas are usually defined in long-term contracts between buying and selling companies. Trading at formula-based contract prices is common in many commodities, and in some the volume of trade at formula-based prices far exceeds that at negotiated prices. An attraction of formula-based prices is that they reduce the risk of disruption of the buyer–seller relationship caused by an impasse in price negotiations or by a buyer or seller reneging on a long-term fixed price contract. If spot prices are volatile, either the buyer or seller in a long-term fixed price contract is likely at some time to want to cheat and buy spot rather than according to the contract. If there were no contract the price would have to be renegotiated frequently, risking an impasse. The buying and selling companies cannot just agree to trade with each other at the current spot price, because that price is usually not clearly defined. Spot transactions typically are arranged privately at prices that are not made public. Buyer and seller need negotiate a formula only once in a while, and formula-based contracts can safely be made long term, if the formula-based price stays close to spot market prices for the same product. Such indexed contracts are common in, for instance, the chemical, food, petroleum, steel, scrap steel, lumber, and natural gas industries.
Much of this book is devoted to supporting the three main findings, but the book also contains descriptive material on pricing. The hope is that such information stimulates thinking about theoretical issues by providing concrete contexts.
1.1 Rigidity of the Prices of Highly Differentiated Products
A key question is why the prices of highly differentiated products do not fall sharply during recessions. Comparison with competitive commodity markets suggests a superficial answer. There are many sellers of a commodity, and the seller with the lowest price can steal as much in sales from higher priced sellers as it can handle. As a result, the demand faced by each seller is extremely elastic, so that when market demand declines, every seller believes it can increase its profits by reducing its price. This mechanism is weaker when products are highly differentiated, because there is only one producer of each good, and the different goods are not good substitutes for each other. Because the goods are not good substitutes, a price reduction by a producer would probably have to be large just to be noticed by those more interested in buying competing products. Nevertheless, it is puzzling that producers of highly differentiated goods reduce prices so little during recessions. There must be some substitutability even among highly differentiated goods, and low sales impose costs on firms that could be reduced by increasing sales. An example of such costs is the loss of skilled employees through layoffs.
Part of the explanation of the dearth of price cuts during slow times may have to do with producers’ attitudes. Producers of highly differentiated products know that because differentiation is a source of market power it is a source of wealth. One of their preoccupations is to protect the differentiation, and one way to do so is to keep customers’ attention focused on a product’s qualities. Producers say that for this reason they try to avoid price change, because price volatility attracts attention to a product’s price rather than its characteristics. Those who choose prices for differentiated products say that price change commoditizes products, where by commoditize they mean attract attention to price and away from a product’s properties. Typically price setters choose prices that seem unlikely to attract attention, then keep the prices constant for a fairly long time, and use a product’s qualities to sell it. This way of choosing prices leads price setters to associate price with product quality, and respondents claim that customers tend to make the same association. A fairly common argument against price reduction is that it can diminish potential buyers’ perceptions of a product’s quality.
One reason producers may wish to avoid price fluctuation is that the administrative process of changing price may be expensive for the seller and for customers as well. I asked about such costs and, with some exceptions, they were said to be insignificant impediments to price change.
When I asked producers of highly differentiated products why they did not reduce prices during recessions, the most common answer was that the quantity sold would not increase or would do so by only a small amount. The second most common answer was that price increases meet such strong opposition that it would be difficult to reverse a price reduction after demand recovered.
If a price reduction would hardly affect the quantity sold, it is natural to assume that a price increase would also hardly do so. Hence we are left with the need to explain why firms do not increase prices during recessions. The explanation, I believe, is that buyer opposition to price increases discourages them.
Respondents offered explanations of why the demand for highly differentiated productive inputs reacts little to price reduction. These explanations form a coherent story, especially when substitution among inputs involves switching costs. These costs inhibit firms from reacting to a decline in the price of an input by substituting it for one or more other inputs. Hence, switching costs tend to make inputs nearly proportional to outputs. Reducing the price of an input is not likely to have much effect on the demand for the output, unless the output has a high elasticity of demand and the input’s cost is a large fraction of the cost of the output. Example 1 in the Appendix illustrates this story. Since the story requires that the output’s elasticity of demand not be high, a full explanation of the lack of response of input demands to price reduction in a recession requires an explanation of modest response of final demands to price reduction, where by final demands I mean demand for consumption goods and capital equipment.
Respondents who set prices for highly differentiated products did not explain clearly why final demands respond little to price reduction during periods of low demand. A possible explanation is the superficial answer mentioned at the beginning of this section. Example 2 in the Appendix is, I believe, a natural formalization of this story. In the example, demand is inelastic at every price, and I encountered no evidence of such wide-ranging inelasticity. The lack of realism of this implication indicates that the story is at best an incomplete explanation.
One could accept provisionally as an empirical regularity price setters’ belief that final demands for highly differentiated products respond little to price reduction, especially during periods of low demand. To go beyond this disappointing stance, one needs more empirical information. One needs to verify that price setters’ beliefs are accurate, that final demands do respond little to price reduction. If it is true that final demands are unresponsive, one needs to know why. More empirical information might eliminate many of the possible explanations that come to mind and open the way to an understanding of the lack of response. A rough summary of what price setters say and imply is that they select a price from a range of prices they believe buyers will find appropriate, hoping the choice will encourage buyers to focus on the product’s qualities. Within the range, demand responds little to price reduction, because the product fills buyers’ specific needs that are quickly saturated. It cannot be said, however, that demand is inelastic, because a price increase might so offend buyers as to reduce demand sharply.
A common response of sellers of all types to demand decline is to increase the use of temporary promotional discounts. When such discounts are applied to highly differentiated goods, normally the price returns after the promotion to its level before the promotion, which in retail trade is called the regular price. This is done in order to convince customers that the discount is indeed a discount that should be taken advantage of while it lasts. Promotions for a particular product are held sufficiently infrequently and the discounts are usually large enough to inspire in customers the impression that the promotion is an unusual opportunity. Vendors believe the discounts increase demand more than would a permanent price reduction of the same size. Temporary discounts are common though not universal in retail trade and in some industrial markets, such as the markets for machine tools. Temporary promotional discounts are a merchandising tool used in good times and bad and should not be confused with reductions in regular or list prices. The responsiveness of demand to temporary promotional discounts does not necessarily contradict a lack of response of demand to reductions in regular or list prices, because a large part of the effect of promotions on demand probably results from shifting purchases through time and concentrating them in a short period.
Opposition to price increases comes from final buyers and from intermediaries, such as wholesalers or distributors and large retailers. Opposition from final buyers comes only when high frequency of purchase makes them aware of price increases. The opposition of final buyers is expressed by complaints, reduced purchases, and switching to substitute products. Large retailers and distributors sometimes refuse to pay price increases, threatening to drop the product. Consumer opposition to price increases is pronounced in the restaurant industry, where consumers are especially apt to notice price increases. In the major household appliance industry, where customers buy too infrequently to be aware of price increases, the opposition to increases comes from large retailers and seems to be effective. In the automobile industry price increases occur even during recessions. This may be so because in this industry most customers buy too infrequently to notice price increases and intermediaries are not in a position to oppose them. It seems that where opposition to price increases exists it does discourage them. A recurrent theme in the interviews was that a strong deterrent to price reductions during a period of slack demand is the anticipated opposition to future price increases made to reverse the reduction.
Manufacturers of highly differentiated products strive to find a hook that will tie a clientele of customers to their product. The hook can be brand loyalty or a customer’s habit of eating a certain food. It can be that a customer knows how to use only certain kinds of computer programs. It can be that a customer’s industrial process requires a certain proprietary chemical. In industrial settings, some manufacturers use an approach to pricing called value pricing, where the seller claims that its product saves the buyer money in its production processes relative to any available alternative and that the product’s price is set so as to share the savings between buyer and seller. Although canny buyers resist such sales pitches, they are nevertheless effective in tieing buyers to certain products. If a manufacturer adheres to a value pricing story, then its price is not affected by product demand.
A somewhat different reason for price rigidity exists when a manufacturer sells a flow of a differentiated product to another company, such as a retailer or another manufacturer. The product might be a component of one of the buyer’s products or it could be a branded good purchased by a retailer to sell to the public. In many such cases, the price is held fixed in part in order to avoid frequent negotiations of price changes, which could disrupt the relationship between buyer and seller if the negotiations failed. Both sides would normally regret such a disruption, the buyer because it needs the product and the seller because of the loss of sales.
Since buyers and sellers of commodities often negotiate prices, one wonders why the difficulty of these negotiations does not make commodity prices rigid. One answer may be that in a commodity market, since all buyers and sellers deal in the same good, it is normally easy to change trading partners if a negotiation stalls. Another answer is that when a buyer and seller are too closely linked to change trading partners easily, they tend to trade at flexible formula-based contract prices rather than rigid prices. Formula-based contract prices often have nearly the same function in commodity trading as can rigid prices in the buying and selling of highly differentiated goods. Both help preserve the relationship between buyer and seller by neutralizing the price adjustment process.
Since product differentiation gives sellers market power, one might conclude that it is market power alone that generates price rigidity. One might imagine that because the producer of a highly differentiated product has a monopoly on the sale of its product, the way to test whether it is market power alone that causes price rigidity is to examine pricing by companies that are the sole producers of an undifferentiated product. Such a test would not be valid, because a product produced by only one firm is by definition differentiated. A test would have to involve an undifferentiated product manufactured by oligopolists with market power. There are nearly undifferentiated products, such as cement, gypsum wallboard, and some kinds of paper and steel that are produced by oligopolists who clearly have market power. The prices of these goods are fairly flexible, though not as volatile as the prices of many commodities. The lack of differentiation can make it so easy for producers of these products to increase profits temporarily by undercutting competitors’ prices, that it is hard for the producers to resist doing so. This is evidence that market power may not be able to create price rigidity unless the seller’s ability to control price is reinforced by product differentiation.
There are large numbers of companies that produce closely related but differentiated products and that compete on product attributes as well as on price. Examples are restaurants, contract manufacturers that produce goods designed by their customers, and contractors in the building trades. Consideration of such companies supports the connection between product differentiation and price rigidity.
Restaurateurs explain that their industry relies on regular customers who eat at favorite restaurants fairly often and in each usually order one of a few dishes. Such customers are likely to notice price increases and to react badly to them. In order to avoid antagonizing and maybe losing some of these customers, restaurateurs hesitate to raise prices and are reluctant to reduce them because of the difficulty of reversing the declines later. In many restaurants, the resistance to price change is due in part to the cost of changing menus or menu boards, but the main concern seems to be the anticipated reaction of customers.
Contract manufacturers bid for work, and awards of work are normally based on the bid and reputation for good service and product quality. The world of contract manufacturers seems to be divided between those who compete mainly by bidding low and those who rely on a reputation for quality work. Those who rely on bidding low seem to react to recessions by reducing bids. Those who emphasize quality use the same arguments for not reducing bids in slow times that producers of highly differentiated goods use for not reducing prices, namely, that price reductions would do little to increase sales and would be hard to reverse after demand recovered.
So much of the pricing in the construction industry is the result of competitive bidding that it is hard to imagine that any downward price rigidity could exist there. Nevertheless, I found a few examples of price stickiness, linked to materials pricing. Those who do not reduce prices in slow times justify their inaction using arguments similar to those used by producers of highly differentiated products.
It is interesting to compare bargaining over commodity prices with that over prices of highly differentiated goods. When manufacturers of highly differentiated goods sell to large companies, such as retail chains, wholesalers, or large manufacturers, customers normally can use their buying power to depress prices. But large buyers usually have trouble holding down the prices of commodities. A large buyer could certainly depress a commodity’s market price by reducing purchases, but then it would buy less product and large buyers typically want to pay a lower price for more product not less. Furthermore, many commodity markets are so large that large reductions in purchases would be required to achieve significant price reductions. Some large buyers of commodities use forward contracting to protect themselves against price increases. For instance, restaurant chains and manufacturers of prepared foods make contracts with food producers that fix prices before the beginning of the growing season. Farmers accept such contracts as protection against price declines.
I came upon two exceptions to stickiness of the prices of highly differentiated products. These are the prices of branded building products manufactured from materials that are commodities with volatile prices. Because the cost of the commodity inputs dominates the cost of the branded products, and contracts with formula-based prices tie the prices of the branded products to the prices of the commodity inputs.
The contrast between the price behavior of undifferentiated products and of highly differentiated products is similar to the contrast between the behavior of wages and salaries of temporary and regular employees. The market for temporary employees is almost an auction market and has fairly flexible wages. The close relationship between employer and regular employees makes it difficult to reduce their pay, because employees expect loyal service to be rewarded by pay increases and so are likely to consider pay reduction to be a betrayal. The parallel between labor and product markets weakens when one compares the consequences of price increases and pay reduction. The main concern about increasing the price of a highly differentiated product is that buyers find substitute products and stop buying. The main concern about reducing the pay of regular employees is that they become less productive, though there is also concern that they may quit.6
1.1.1 Macroeconomic Implications
An interview study of pricing ought to give insights into the inflation process. Unfortunately, I have nothing to say about this matter, because there was little inflation when I was interviewing and few respondents were in positions of responsibility during earlier inflationary periods.
An important theme in the interviews was that vendors of highly differentiated products often encounter strong resistance from customers to price increases. The resistance is to be expected since buyers can usually identify the vendor as responsible for a price increase. The resistance was described with such vehemence that one wonders that there could ever be inflation of the prices of such products. The recent inflation shows that the resistance can be overwhelmed. Probably inflation weakens the resistance by diffusing responsibility for increases. Highly differentiated products are so widespread that the resulting upward stickiness of their prices is probably enough to explain why nominal increases in aggregate demand can have real effects, even during periods of inflation. Similarly, employers’ reluctance to cut pay and the reluctance of vendors and manufacturers of highly differentiated products to reduce prices should be enough to explain how reductions in nominal aggregate demand can have real effects.
1.1.2 Related Literature
There is an interesting theoretical literature on switching costs that deals mainly with issues in industrial organization: see von Weizsäcker (1984); Klemperer (1987a, 1987b, 1987c, 1989, 1995); and Beggs and Klemperer (1992). These authors capture part of the intuition of how switching costs can contribute to price inflexibility. They point out that in markets with switching costs a firm’s price reduction may attract few new customers, because the costs discourage customers of rival firms from taking advantage of the reduced price: see von Weizsäcker (1984, p. 1103); and Klemperer (1987b, p. 386).
A well-known theory of price rigidity is the kinked demand curve theory of Hall and Hitch (1939); Sweezy (1939); and Abreu, Pearce, and Stacchetti (1986). According to this theory, oligopolists who all produce the same product, or close substitutes, refrain from reducing prices, because rival firms will match reductions. Similarly such oligopolists refrain from raising prices, because no competitor will match increases. Some respondents mentioned that they had to be cautious about cutting prices, because rivals might match the reductions. Such concerns no doubt inhibit price cutting.
Strictly speaking, the kinked demand curve theory does not apply to producers of highly differentiated products, since such products by definition have no close substitutes. When a producer of a highly differentiated product lowers its price, the concern is not that rivals will reduce their prices too but that, even if they don’t, their customers will not leave them to take advantage of the lower price. When a producer of a highly differentiated product raises its price, the concern is not that rivals will not raise their prices but that, even if they do, the price increase will provoke the producer’s customers to look for an alternative product and perhaps shift patronage to it.
The logic of the kinked demand curve argument applies no matter how many sellers there are. Kinked demand curve behavior, however, requires that different sellers coordinate their price setting, which may be difficult if the sellers are numerous. The wild behavior of many commodity prices indicates that the coordination normally does not occur when there are many sellers of a commodity. Thus, it seems appropriate to assume that the kinked demand curve theory applies only when there are few sellers of the same product or of close substitutes.
An argument against the kinked demand curve theory is that the prices of nearly undifferentiated goods do seem to be somewhat flexible, even when there are so few sellers that the kinked demand curve theory ought to apply. I have alluded to the cement and gypsum wallboard industries as examples of such flexibility.
Arthur Okun provides an explanation of price rigidity in some ways similar to that presented here. His explanation is inspired by consideration of retail trade (Okun, 1981, ch. 4). He focuses on the search costs of consumers who shop at different retailers looking for the lowest prices. He observes that retailers can reduce consumers’ search costs by always having low prices that consumers can count on. He asserts that some retailers attract and retain loyal customers by having consistently low prices. He interprets the commitment to steady low pricing as part of an implicit contract between buyer and seller. Okun argues that there are customers throughout the economy, not just in retail trade, that favor certain sellers for similar reasons. He calls markets with such attachments customer markets. He reasons that prices in customer markets do not fluctuate much, because sellers wish to attract regular buyers by reducing their costs of searching for the seller with the lowest price. He contrasts customer markets with what he calls auction markets, which are competitive markets where prices fluctuate in response to changes in supply and demand.
The steady low pricing that Okun attributes to some retailers is the marketing strategy used by what are called everyday low price supermarket chains. They have few promotional discounts, though they usually do pass on to consumers fluctuations in the wholesale prices of fresh foods. There are many successful grocery chains, however, that use an opposite pricing strategy, called high-low, which uses heavily advertised temporary promotional discounts to attract customers. Many vendors of all kinds use similar pricing strategies successfully to entice customers. Okun is correct, I believe, in pointing out that some of the price rigidity in the economy is a consequence of alliances between buyers and their suppliers. My conclusion is that those alliances stem not from reduction of buyers’ costs of searching for the lowest price, but from investments made by buyer and seller that make trade between them possible or from switching costs that make it difficult for a customer firm to replace an input purchased regularly from another firm.
1.2 The Behavior of Marginal and Average Variable Costs as a Function of Output
For many manufacturing processes, the behavior of marginal and average variable costs as a function of output is governed by technology. For instance, if the production equipment is designed to operate at one speed, labor and material costs are nearly proportional to output. In some businesses, respondents could not speak sensibly of the relation between output and marginal or average variable costs, because their plants’ equipment runs around the clock at a nearly constant speed and shutting or slowing it down can damage it and incur startup costs. Iron and aluminum smelters, cement kilns, petroleum refineries, and paper mills face such constraints.
A technological issue is one of the explanations given for decreasing marginal and average variable costs. Many factories use the same equipment to produce a variety of products, and manufacturers count as variable the setup cost of changing a production line from one product to another. Usually the larger are orders for a product, the longer are its production runs and hence the lower are changeover costs per item produced and the lower are marginal and average variable costs of production.
The other common explanations for decreasing marginal and average variable costs have to do with attitudes of the work force. When activity in a workplace declines, workers are likely to slow down in the hope of preserving their jobs. A high production rate also creates a sense of urgency that inspires employees to work hard and imaginatively.
Initially, I asked about marginal variable costs, but found that few respondents fully grasped the concept. I therefore switched to asking about average variable costs, except when I learned that the respondent understood marginal cost. All respondents seemed to be familiar with average variable costs. The switch does not weaken the import of the basic finding, because if average variable costs remain constant or decline as output increases, then the product of output and marginal variable costs is less than or equal to total variable costs. Hence a firm that sets price equal to marginal variable cost earns no more than its total variable cost and so earns no margin to pay for fixed costs and profit. This is the conclusion of interest. A reason for thinking of the findings as applying to marginal as well as average variable costs is that the reasons respondents gave for constant or declining average variable costs imply constant or declining marginal variable costs as well.
In a firm with more than one production line for each product, marginal variable costs may increase with the firm’s output, even if the marginal variable cost of each line does not do so. This is so, because the firm may use its most efficient lines when output is low and use older less efficient lines as output increases. Although it is true that even some small manufacturing companies have multiple lines for producing a product, I conclude from respondents’ emphasis on the increase in productivity with output that the effects of increased use of less efficient lines in good times is normally more than offset by other productivity enhancing effects of increased output.
The assertions regarding marginal variable costs are supported by the findings of Blinder et al. (1998, p. 102). These authors estimate that about half of the U.S. gross national product is produced by firms with constant marginal costs and another forty percent is produced by firms with declining marginal costs. Blinder and coauthors found, as I did, that some respondents were not comfortable with the concept of marginal costs.
1.3 The Treatment of Fixed Costs by Manufacturers of Products that Are Not Commodities7
Some of the evidence for constant or declining marginal variable costs has to do with how manufacturers of goods that are not commodities treat fixed costs. If manufacturers’ marginal variable costs increased with output, then those who both produce for competitive markets and set their own prices might be able to set prices equal to marginal variable cost, cover fixed costs, and make a profit. This is so, because marginal variable costs would exceed average variable costs. Although many of the 246 manufacturing firms where I interviewed both faced stiff competition and could set their own prices, few were in this happy situation, and many had to charge more than marginal variable cost just to break even. Many firms arrange to charge more than marginal variable cost by basing price on fully absorbing cost systems. Although manufacturers use these cost systems flexibly, the results seem not to be marginal cost pricing, which some respondents frowned on. They were concerned that it would cause their factories to be very busy producing low margin products at a loss.
1.4 The Treatment of Fixed Costs by Commodity Manufacturers
Another test of assertions regarding marginal variable costs is to see if commodity producers treat fixed costs in a way consistent with marginal
