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Price rigidity and exibility: recent theoretical
developments - Introduction to the Special Issue
Daniel Levy
To cite this version:
Daniel Levy. Price rigidity and exibility: recent theoretical developments - Introduction to the Special
Issue. Managerial and Decision Economics, Wiley, 2007, 28 (6), pp.523-530. �10.1002/mde.1331�. �hal-
02387429�
Price Rigidity and Flexibility:
Recent Theoretical Developments
Introduction to the Special Issue
Daniel Levy*
Guest Editor of the Special Issue
Department of Economics, Bar-Ilan University, Ramat-Gan 52900, ISRAEL
Abstract: The price system, the adjustment of prices to changes in market conditions, is
the primary mechanism by which markets function and by which the three most basic
questions get answered: what to produce, how much to produce and for whom to
produce. To the behaviour of price and price system, therefore, have fundamental
implications for many key issues in microeconomics and industrial organization, as well
as in macroeconomics and monetary economics. In microeconomics, managerial
economics, and industrial organization, economists focus on the price system efficiency.
In macroeconomics and monetary economics, economists focus on the extent to which
nominal prices fail to adjust to changes in market conditions. Nominal price rigidities
play particularly important role in modern monetary economics and in the conduct of
monetary policy because of their ability to explain short-run monetary non-neutrality.
The behaviour of prices, and in particular the extent of their rigidity and flexibility,
therefore, is of central importance in economics. This introductory essay briefly
summarizes the eight studies of price rigidity that are included in this special issue.
* Correspondence:
Department of Economics, Bar-Ilan University, Ramat-Gan 52900, ISRAEL; Tel:
+972-3-531-8331; Fax: +972-3-535-3180; Email: Levyda@mail.biu.ac.il.
Last Revision: July 30, 2006
JEL Codes: D21, D40, E12, E31, E50, E52, E58, L11, L16, M20, M30
Key Words: Price Rigidity, Price Flexibility, Cost of Price Adjustment, Menu Cost,
Managerial and Customer Cost of Price Adjustment, New Keynesian Economics, Price
System
Forthcoming
Managerial and Decision Economics, 2007
Special Issue - Price Rigidity and Flexibility: Recent Theoretical Developments
1
INTRODUCTION
The price system, the adjustment of prices to changes in market conditions, is
perhaps the single most important mechanism in a market-based economy. It is the price
system that ensures that markets produce and offer the goods and the services that people
want. It is the price system that ensures that the quantities produced are indeed the
quantities that people and consumers would like to purchase. It is the price system that
ensures that the products and services produced will end up in the hands of those that
value them most. In short, the price system is the primary mechanism by which market-
based economies function and by which the three most basic questions get answered:
what to produce, how much to produce and for whom to produce.
To the behaviour of price and price system, therefore, have fundamental
implications for many key issues in microeconomics and industrial organization, as well
as in macroeconomics and monetary economics. In microeconomics, managerial
economics, and industrial organization, historically the economists’ interest has been in
the efficiency of the price system and in the resulting market outcomes. That is, the
process by which price adjustments to changes in market conditions lead to efficiency of
the market system and the resulting equilibrium allocations. In macroeconomics and
monetary economics, the primary focus of the economists has been on the extent to which
nominal prices fail to adjust to changes in market conditions. This type of nominal price
rigidities play central role in modern monetary economics because of their ability to
explain short-run monetary non-neutrality.
The behaviour of prices, therefore, is of central importance in economics. At the
theoretical level, it is important to study models with various types of rigidities. For
example, all models with Keynesian or New Keynesian flavour rely on some form of
price (or wage) rigidity in order to generate predictions that fit the behaviour of the
aggregate data. Therefore, it is critical to study and understand what is the nature of the
barriers to price adjustments, how these barriers lead to sluggishness in price adjustment,
and what do these mechanisms imply for various issues and questions at the level of both
microeconomics as well as macroeconomics.
During the last 15–20 years, we have witnessed a remarkable revival in the
popularity of New Keynesian models, that is, models that incorporate various forms of
2
price rigidities as the main source of friction that generates monetary non-neutrality.
Some of these studies have been published in the edited volumes by Mankiw and Romer
(1991a, 1991b) and Sheshinski and Weiss (1993), which also contain references to other
related studies. Since the publication of these volumes, however, there have been
numerous developments in the theoretical literature. The goal of this special issue is to
report some of these developments.
At the empirical level, it is important to assess the extent of price rigidity and
flexibility. In particular, studying whether or not prices adjust to changes in market
conditions as the standard New Classical model predicts seems to be of particular
importance. In response to recent theoretical developments, the literature has also begun
producing during the last 10–15 years empirical studies of price rigidity using various
types of micro-level data from the US as well as from the European Union member
countries. Two forthcoming special issues of the Managerial and Decision Economics
(Levy, 2006 and 2007) will include some of these empirical studies.
IN THIS ISSUE
This special issue of the Managerial and Decision Economics contains eight
theoretical contributions. These papers address the topics of price rigidity and flexibility
from various angles. Of the eight studies, the first is a broad and updated survey paper.
The second paper provides a sociological perspective on price rigidity and offers a new
methodological contribution. The third paper offers a marketing perspective on price
rigidity linking it to the issue of reference price. The latter plays a central role in
marketing, both in theory as well as in practice. The fourth paper focuses on non-price
adjustment mechanisms by suggesting that prices may be rigid, if waiting time, i.e., the
delivery lag, can respond endogenously to changes in market conditions.
The remaining four papers focus on macroeconomic implications of rigid prices and
costs of price adjustment. One of the four papers studies the optimality of price stability,
which is a topic of particular interest to monetary policy makers and to students of
monetary policy. The second paper studies a model which can yield a hump-shaped
inflation response to monetary policy shocks of the type frequently documented by
empirical studies using variety of US as well as other countries' aggregate data. The third
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paper analyses an equilibrium optimization model to explore the interaction between
price rigidities and inventories and its role in the propagation of business cycles. Finally,
the fourth paper compares the real effects of trend inflation and monetary shocks in
discrete and continuous time versions of a simple New Keynesian model.
The paper by Alex Wolman, “The Frequency and Costs of Individual Price
Adjustment,” is a remarkably thorough survey of over 100 theoretical and empirical
studies, all focusing on price rigidity, one way or another. The theoretical studies
Wolman surveys, all use rigid prices as one of the key ingredients of their modelling
strategy. The empirical studies—and Wolman surveys no less 50 of them, all try to assess
the extent of price rigidity directly or indirectly, or study various issues relevant for price
rigidity and flexibility, such as measurement of price adjustment costs such as menu costs
or managerial and customer costs, and assessing the relevance of these costs for price
rigidities that have been documented by empirical studies.
Besides its broad coverage, Wolman’s study is unique because of the attention it
gives to earlier studies of Mills (1927) and Means (1935a, 1935b, 1936), which have not
been reviewed thoroughly in the post 1980s literature. The studies by Mills and Means
have been extremely influential, although as Wolman notes, they are not without
shortcomings.
In addition, Wolman provides a fascinating discussion of the early literature,
including Keynes (1928), Hicks (1935) and Scitovsky (1941), as well as less known
correspondence between Means and Galbraith (1936). It turns out that these studies and
the exchange between Means and Galbraith, discusses and suggest the idea of price
adjustment cost and its various facet, perhaps anticipating the ideas of Akerlof and Yellen
(1985a, 1985b) and Mankiw (1985).
In the paper titled “A Sociological View of Costs of Price Adjustment:
Contributions from Grounded Theory Methods,” Mark Zbaracki offers a sociologist’s and
organizational behaviour scientist’s perspective on the empirical approach that is based
on hypothesis testing, which dominates the economics discipline. Zbaracki argues that the
economic theory and data often pose problems that cannot be addressed with the existing
econometric methods that are designed to test hypotheses. For example, theories of price
adjustment costs rely on variables that cannot be observed. Although in principle such