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7.7.1 Other sources of real price rigidity

We have already noted that mild sensitivity of marginal cost to variations in

output and procyclical elasticity of demand (implying a countercyclical markup)

will contribute towards real price rigidity. The new Keynesian literature

has also identified several other potential sources of real price rigidity.

Thick market externalities In the real world buyers and sellers are not

brought together without incurring search costs. Consumers must spend time

searching the market for the goods they desire and firms advertise in order to

attract customers. Workers and employers must also spend time and resources

searching the market. When markets are thick during periods of high

economic activity it seems plausible that search costs will be lower than is

the case in a thin market characterized by a low level of trading activity (see

Diamond, 1982). It may also be the case that people are much more willing to

participate in thick markets where a lot of trade is taking place and this leads

to strategic complementary; that is, the optimal level of activity of one firm

depends on the activity of other firms. If these thick market externalities help

to shift the marginal cost curve up in recessions and down in booms, then this

will contribute to real price rigidity.

Customer markets The distinction between auction and customer markets

has been developed by Okun (1975, 1981). The crucial characteristic of a

customer market is a low frequency of search relative to the frequency of

purchase (McDonald, 1992). Most products are sold through a process of

shopping and, providing the costs of searching the market are non-trivial, the

buyer will always have imperfect (limited) information concerning the lowest

price in the marketplace. Because of the search costs associated with the

shopping process, sellers have some monopoly power even though there may

be a large number of firms in the market, each selling a similar product. Since

a large number of customers make repetitive purchases it is in the interests of

any firm to discourage its customers from searching the market in order to

find a better deal. Firms are therefore discouraged from frequently changing

their prices, a practice which will provide an incentive for customers to look

elsewhere. Whereas an increase in price will be noticed immediately by

customers, a decrease in price will produce a much smaller initial response as

it takes time for this new information to reach the buyers at other firms. This

difference in the response rates of customers to price increases and decreases,

and the desire of a firm to hold on to its regular customers, will tend to

produce relative price stickiness (see Phelps, 1985, for an excellent discussion

of customer markets).

Price rigidity and the input–output table Gordon (1981, 1990) has drawn

attention to the complexity of decision making in a world where, typically,

thousands of firms buy thousands of components containing thousands of

ingredients from numerous other firms, many of which may reside overseas.

‘Once decentralisation and multiplicity of supplier–producer relationships

are recognised, no single firm can perform an action that would eliminate the

aggregate business cycle’ (Gordon, 1981, p. 525).

Because a firm is linked to thousands of other firms via a complex input–

output table, it is impossible for it to know the identity of all the other agents

linked together in the web of supplier–producer relationships. Because of this

complexity there is no certainty that marginal revenue and marginal cost will

move in tandem following an aggregate demand shock. There is no certainty

for an individual firm that, following a decline in aggregate demand, its

marginal cost will move in proportion to the decline in demand for its products.

Many of its suppliers may be firms in other countries facing different

aggregate demand conditions. To reduce price in these circumstances is more

likely to produce bankruptcy for the particular firm than it is to contribute to

the elimination of the business cycle because a typical firm will be subject to

both local and aggregate demand shocks as well as local and aggregate cost

shocks. As Gordon (1990) argues, in such a world no firm would be likely to

take the risk of nominal GNP indexation that would inhibit its freedom and

flexibility of action in responding to the wide variety of shocks which can

influence the position of its marginal revenue and cost curves. Since indexation

is undesirable when there is substantial independence of marginal cost

and aggregate demand, Gordon’s input–output theory not only provides an

explanation of real price rigidity but also translates into a theory of nominal

rigidity. The fundamental reason for the gradual adjustment of prices is that

this represents the safest course of action for firms operating in an uncertain

world where information is inevitably imperfect.

Clearly the informational requirements necessary for rational pricing behaviour

in every period are enormous for price-setting firms. Not only do

they need to know the position and shape of their demand and cost curves;

they also need to predict the pricing behaviour of all the other firms in the

input–output table. Since the firm’s demand and cost curves are influenced by

aggregate demand, it is also necessary for firms to predict the value of all the

relevant macro variables that influence aggregate demand. In short, the decision

makers within monopolistically competitive firms need to be first-class

general equilibrium theorists with perfect information! Given these complications,

the tendency of firms to follow simple mark-up pricing rules may be

close to optimal. The incentive to follow such rules is reinforced if other

firms do likewise, since this ensures that a firm will maintain its relative

price, which will tend to minimize its losses (see Naish, 1993). Another

simple rule which a firm can follow in a complex input–output world is to

wait until other firms raise or lower their price before initiating a change.

This produces staggering in price setting, which implies that the price level

will take longer to adjust to an aggregate demand shock.

Capital market imperfections An important obstacle to firms seeking external

finance is the problem of asymmetric information between borrowers and

lenders; that is, borrowers are much better informed about the viability and

quality of their investment projects than lenders. One consequence of this

will be that external finance will be more expensive to a firm than internal

finance. During booms when firms are making higher profits there are more

internal funds to finance various projects. Hence during recessions the cost of

finance rises as the result of a greater reliance on external sources. If the cost

of capital is countercyclical, this too will tend to make a firm’s costs rise

during a recession (see Bernanke and Gertler, 1989; D. Romer, 1993).

Judging quality by price Stiglitz (1987) has emphasized another reason

why firms may be reluctant to reduce price when faced with a decline in

demand. In markets where customers have imperfect information about the

characteristics of the products which they wish to buy, the price may be used

as a quality signal. By lowering price a firm runs the risk that its customers

 (or potential customers) may interpret this action as a signal indicating a

deterioration of quality.

Having examined several potential sources of real rigidity in the product

market, we will now turn to real rigidities in the labour market. If real wages

are rigid in the face of demand disturbances, this substantially reduces a

firm’s incentive to vary its price as a response to such disturbances.