Sticky Prices, Inflation, and Markups

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In the past, I have written about examples that seem like they challenge really basic notions of supply and demand. One example that I’ve written about is the behavior of restaurants in college towns on football weekends. On the night before a big football game, restaurants in these small towns have very long wait times. In theory, rather than having a long line, they could simply adjust prices until the wait times disappeared. They do not do this.

Armen Alchian used a similar example of news stands. The newspaper has the same price all day. Despite significant fluctuations in demand throughout the day, the price of the newspaper is always the same. During times when demand is high, people tend to wait in a line to buy their newspaper.

At first glance, this seems like it violates supply and demand. Aren’t prices supposed to adjust to supply and demand?

There are a number of explanations why firms might do this. Alchian’s argument has to do with search costs. If prices are fluctuating throughout the day, people might make trips to multiple news stands to check on the price and there is uncertainty about the price they will pay. Search and uncertainty about the price are also costly. Evidently, firms have discovered that people would prefer to wait in a line rather than dealing with the costs of searching for the cheapest newspaper and never knowing for certain what they will pay.

Another argument is given by David Haddock and Fred McChesney. They argue that firms value their reputation and their “brand.” Since differentiation between brands is often about the quality of the good or service, firms have an incentive to keep their prices relatively constant such that consumers are easily able to assess the price-to-quality ratio of the good or service. In other words, to put this into the language of popular marketing, providing the same great good or service at the same great price over a long period of time is a way of building brand loyalty with customers. By contrast, a firm that is changing its price frequently creates uncertainty about this relationship. The quality of the good or service might always be the same, but the price paid for that quality is fluctuating. The fact that firms keep prices constant implies that it is better for firms to sometimes have shortages (e.g., not enough tables, not enough newspapers) than to constantly adjust prices to market conditions.

If one takes these ideas seriously, it is possible to have a much richer understanding of recent events. For example, many people have pointed to rising mark-ups of prices over costs and rising inflation and drawn the conclusion that the rising mark-ups are the reason why we have inflation. However, the sticky price argument that I just described is perfectly capable of explaining these observations without the mental gymnastics of the alternative explanation.

Imagine a firm is committed to a particular price-to-quality ratio. The firm initially sets it price so that it is profit-maximizing and sticks with that price. If the firm is actually committed to that price, then random fluctuates in demand will only affect the firm’s production (and profits). The firm is not profit-maximizing in the typical textbook sense. There will be periods when the price is too high and when the price is too low given the demand for the product.

The firm need not be stuck with that price forever. Nonetheless, the logic of Haddock and McChesney implies that there is some sort of reputational cost that is incurred if the firm raises its price.

The firm is essentially faced with an optimal stopping problem. In other words, it makes sense for the firm to follow this strategy until it is worth paying the reputational cost to change its price. Typically, this suggests that firms will stick with the constant price until the additional profit the firm could earn is some multiple of the reputational cost. The intuition is simple. The firms doesn’t want to immediately change its price the moment the additional profit exceeds the reputational cost because there is uncertainty about future demand. If the firm changes its price immediately and demand persistently declines, the firm would have been better off doing nothing. The firm paid a reputational cost and didn’t get the corresponding benefit. By waiting until the additional profit is some multiple of the reputational cost, the firm avoids this problem.

What this means is that the optimal thing for firms to do most of the time is nothing. The firm just keeps its price fixed to build and maintain the reputation of the firm and its brand as providing a particular quality good or service at the same price. Even though this might not maximize profits in the immediate term, it does maximize profits in the longer term by building up brand loyalty.

If most firms are typically doing nothing, that means that in any given period of time, most firms are not changing their prices. Only a small fraction of firms change their price each period.

Now, consider what happens when there is a period of both expansionary monetary policy and expansionary fiscal policy. When this happens, the demand for most products will tend to rise, perhaps very significantly. Since demand is driven by expansionary policies, the increases in demand will be widespread. If the change in demand is significantly large, then a large fraction of firms will be willing to pay the reputational cost to raise prices. Thus, prices on average will rise and perhaps rise significantly.

This process explains how sticky prices, mark-ups, and inflation are all related. Inflation isn’t caused by the higher mark-ups. The higher mark-ups are caused by firms adjusting their prices in response to a significant enough increase in demand to justify the reputational cost. The process by which firms adjust these prices isn’t the cause of inflation, it is inflation. The actual cause of inflation is the thing that caused the increase in demand, which was expansionary monetary and fiscal policy.