Sticky Prices

Rahul Nath

In this lecture note I provide some further details on:

• Monopolistic competition and optimal pricing decisions

• The model of Ball, Mankiw and Romer (1998)

• Modelling with the Calvo mechanism

1 Monopolistic Competition
Monopolistic competition is a market structure with imperfect competition that
is characterised by many producers, each producing a differentiated good, and
few barriers to entry/exit. The production of a differentiated good gives these
firms some degree of monopolistic power in the small niche of the market they
occupy, thereby enduing them with the power to set prices for their output.
This is due to the fact that the goods, by virtue of some quality, are seen as
being imperfect substitutes. The number of firms renders the strategic interac-
tion of oligopoly mute, so firms take the decisions of all other firms as given and
out of their control; furthermore they do not consider how their decisions affect
their competitors. This is much like perfect competition. Hence, monopolistic
competition is a market structure that lies somewhere between monopoly and
perfect competition but without the strategic interaction concerns of oligopolies.

Firms operating in a monopolistically competitive market face a downward slop-

ing demand curve for their goods. Unlike perfect competition, a change in price
has consequences for the amount of the good demanded.1 This downward slop-
ing demand is given by,
 −ε
pi
yi = y (1)
p
where yi is the output produced by firm i, pi is the price set by firm i for it’s
output, y is the total output produced, and p is the aggregate price level. The
1 Recall that in perfect competition the seller takes the market price as out of their control

due to their atomistic size. Furthermore, their atomistic size means that they can sell any
feasible amount of output without having appreciable impact on total output, hence market
price.

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firm can control the first two, but has no control over the later two as these are
determined in aggregate.2

The parameter ε measures the elasticity of demand for the the good produced
by firm i; it is the same for all firms and exogenously determined. As ε −→ 0
demand becomes completely inelastic and we have the case of an absolute
monopoly - i.e. output is fixed and any price level is feasible. At the other
extreme, as ε −→ ∞ demand becomes completely elastic and we have the case
of perfect competition - i.e. any level of output can be sold at the fixed price
level.

1.1 Selecting the Optimal Price: p∗i

For the sake of clarity we will assume that the firm only needs to decide how
much labour to hire in production, relaxing this assumption does not qualita-
tively affect the results. The firm chooses the price level to maximise it’s profit
each period

max pi yi − wli
 −ε
pi
s.t. yi = y
p
yi = f (k, li )

where pi yi is the total revenue, wli is the total cost3 , the first constraint is the
demand curve faced by the firm, and the second constraint is the production
function/feasibility constraint. The firm chooses price, output, and labour input
to maximise profits. Solving this problem yields the following conditions,

p∗i ε w 1
=
p 1 − ε p M P Li
µi
w=
M P Li

where µi is the marginal cost. The first condition is essentially the PS equa-
tion, it says that the optimal price is set as a mark-up over the effective cost of
labour.4 . The second condition implies that all firms hire the same amount of
2 This demand curve is derived from the household’s optimisation problem, however analysis

of this problem is beyond the scope of this course. All you need to know is that this is the
general demand curve.
3 This is the total wage bill, where the firm has no control over the nominal wage demanded

by workers. Recall the WS-PS lectures where workers demand a nominal wage, then firms set
a price to achieve a given real wage
4 See Lecture 5 slides on Deriving the PS Curve

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 Figure 1: Equilibrium under Monopolistic Competition

labour, hence have the same marginal cost.5 Taken together, this implies that
all firms that can freely choose prices will set the same optimal price, p∗ .

1.2 Illustration of Equilibrium

The constrained optimisation problem also yields, as an intermediate equation
the condition that gives the general price setting condition, i.e. M R = M C.
Working through the maths one gets a marginal revenue curve that lies below
the average revenue curve.6 The marginal cost curve is an increasing function
in output. One can represent equilibrium in the market according to Figure: 1.
The firm sets prices off the average revenue curve where M R = M C. Under
perfect competition the equilibrium is at A, while under monopolistic competi-
tion the equilibrium is at B. So one notes that monopolistic competition leads
to a restriction of output below the efficient level and an increase in prices above
the efficient level.7 Figure: 1 will play a central role in the analysis of menu
costs and sticky prices.
5 The argument here relies on wages being set by workers independent of the type of firm

(note the wage is not subscripted by i), if all firms also use the same production function then
in order to ensure workers work in all firms they must hire to the point where marginal costs
are equalised across firms. This implies marginal costs are equal across firms
6 The Average Revenue curve is given by dividing the demand cruve by total output, i.e.
yi
y
.
7 NOTE: We always refer to the equilibrium under Perfect Competition as the efficient

level.

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2 The Micro-foundations of Sticky Prices: The
Ball, Mankiw, Romer Model
Micro-founded models look at the individual behaviour of firms and households
to see how individual decisions may lead to the aggregate behaviour observed
in the real world. The menu cost model of Ball, Mankiw, Romer (1988) (BMR)
is one model that demonstrates how price stickiness may be rationalised by in-
dividual firms following their optimal behaviour.

The cost of changing prices referred to as ‘menu costs’ in the literature. Con-
sider a restaurant, or other shop, considering the decision to change it’s prices.
If the firm changes it’s prices then it must also incur a cost associated with the
need to print new menus (if a restaurant), new catalogues (if a shop), printing
price labels, and advertising campaigns, etc required to detail the new prices of
products. The idea behind the menu cost model of sticky prices is that firms
need to consider this additional cost of changing prices with the added profit
that may be earned if they do change prices.

BMR provides a micro-founded model that demonstrates how even small menu
costs can generate price inertia, i.e. sticky prices. The idea behind the model
is that firms make decisions considering only their private costs, and not taking
into account the impact from all other firms changing prices on the aggregate
price level. When considering only private costs the presence of even small costs
may provide sufficient incentive to not change prices in response to every shock
that hits the economy. Only those shocks that are considered ‘bad enough’ lead
to firms being willing to incur the cost of changing prices as the loss in profit
from not doing so leads to even larger losses.

The fact that firms only consider their private costs, and not that of other
firms, may seem, prima facie, to contradict Rational Expectations. However,
under monopolistic competition the number of firms renders the benefits strate-
gic interaction mute and any strategic pact (i.e. collusion) will be extremely
unstable. So firms take the decisions of all other firms as given and out of their
control; furthermore they do not consider how their decisions affect their com-
petitors. If firms have Rational Expectations then they know that they are in a
market characterised by monopolistic competition and so make their decisions
optimally given this market structure. That is, firms only consider their individ-
ual cost/benefit, and take that of others as given. Hence, the behaviour of firms
under monopolistic competition does not contradict Rational Expectations.

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2.1 BMR Assumptions
BMR assume the following:

1. Imperfect Competition: In particular the assumption is that firms operate

in a market characterised by monopolistic competition.

2. Rational Expectations: This means that all firms know the model, i.e.
they know all of the assumptions and act accordingly

3. Firms have one scheduled price adjustment each year that does not incur
a cost, and that the scheduled date is assigned randomly according to a
uniform distribution. So if scheduled price adjustment is once a year, the
1
uniform distribution assumption means that we expect that 12 firms will
be able to change their price each month.

• If a firm is in a period where they are scheduled to change their prices

they still must pay a menu cost. Since the exact price adjustment
period is known ahead of time it is treated as a sunk cost and does
not affect their decisions. That is, the cost associated with printing
new ‘menus’ is seen as a cost of doing business and already accounted
for. They do not pay aadditional marginal menu costs for changing
their prices.

4. If firms choose to change their price outside of their scheduled month they
must pay a cost for adjusting their prices. This cost is the menu cost

Our analysis focuses on the pricing behaviour of firms in response to a shock,

i.e. there is some change in the economy that necessitates a change in price. We
look specifically to the actions of those firms that are not scheduled to change
prices and hence must pay the menu cost to set their price to the optimal level.

2.2 The Flexible Price Benchmark

We begin our analysis with the flexible price model as a benchmark. This allows
us to analyse the optimal behaviour of firms, and the market before studying
how the introduction of menu costs might alter this behaviour. In the flexible
price model all firms are free to change their prices in any period regardless of
whether it is scheduled, and changing prices incurs no cost.

Suppose that there is a negative demand shock at the aggregate level. This
leads to a shift left of the demand curve, which then leads to a shift left of the
AR and MR curves for the individual  firm.
 This is depicted in Figure: 2. So
each firm will reduce their price to ppi so that M R0 = M C. The individual
2

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 Figure 2: Flexible Price Equilibrium

firm moves from equilibrium at A to equilibrium at B.

Now let us consider what happens to the whole economy. If all firms reduce
their prices then the aggregate price level drops. This fall in the price level
raises aggregate demand, which perfectly counters the negative demand shock.
This increase in aggregate demand shift out the AR’ back to AR for each firm.
This is due not to the fall in individual prices, but rather the effect of the ag-
gregate price level falling. Thus we end up back at A as a result of aggregate
firm behaviour, even though each firm is only acting in it’s best interest.

This flexible price mechanism under rational expectations explains why the
economy never moves from equilibrium output. It is because individual firm
behaviour ensures aggregate prices move so as to counter any output impact.
In this sense the flexible price, rational expectations equilibrium will always be
self-correcting with respect to output. The change in the aggregate price level
due to the shock is the change in inflation seen in the rational expectations
IS-PC-MR diagram.

2.3 Menu Costs and Sticky Prices

Let us now see what happens if firms that change their price outside of their
scheduled period must pay a cost for doing so. We consider a negative aggregate
demand shock, as before, however there are now two groups of firms:

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 Figure 3: Menu Cost Model

1
1. Firms in scheduled price change period: 12 firms have scheduled price
change in the period of the shock so pay no additional menu cost beyond
what they already know will be incurred. These firms will set their price
at the optimal level.
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2. Firms outside their scheduled price change period: 12 firms are outside
their scheduled price change period. If these firms choose to change their
price to the optimal level as well they must pay a fixed menu cost of M.

Our interest is in the decisions of the firms that are outside of their scheduled
price change period. This is represented in Figure: 3. The firms have to decide
between:

1. Don’t Change Prices: This is point C in Figure: 3

2. Change Prices: This is point B in Figure: 3. We know that firms that

choose to change their prices will pick the optimal point; to pick any other
point would be sub-optimal.

If the firm chooses not to change prices it faces a cost, in terms of lost profits,
that can be decomposed into two components:

1. Private Cost: The firm loses profit equal to the grey triangle in Figure: 4.
This is the loss due to holding prices above the optimal level and hence
selling a lower amount of output. This is a private cost to the firm because
the opportunity to reduce this is within the direct control of the firm.

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 Figure 4: Profit Loss Decomposition

2. Market Cost: The firm loses profit equal to the orange hashed trapezoid in
Figure: 4. This is the loss to the firm of the aggregate price in the economy
being higher than previously as some firms do not reduce prices to the
optimal level. This mutes the aggregate demand mechanism discussed in
the flexible price benchmark. This is a market cost arising from firms not
all coordinating their pricing changes. This is a cost that is outside of
the individual firms control as it depends on the behaviour of all market
participants.

The firm cannot control the pricing decisions of other firms in the market and
so only considers it’s own private costs, i.e. it only compares the menu cost
to the grey triangle. Thus there is an coordination externality, the orange
trapezoid, that is not considered.8 So long as the menu cost is larger than the
grey triangle firms will optimally choose not to change their price to the optimal
level since the cost is larger than the extra profit that can be gained. Indeed,
firms outside of their scheduled price change period will only change their prices
in response to a shock if that shock is sufficiently large so that the additional
profit gained exceeds the menu cost of changing prices.

It is also worth noting that since firms face the same marginal cost curve (see
arguments above for this) they face the same profit gain from changing prices.
So if one of these firms finds it optimal to change their price outside the sched-
8 Thisis often referred to as a coordination problem as it results from firms not being able
to coordinate prices. Such coordination in prices are ruled out by government anti-collusion
laws.

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uled window then so will all of the others!

The menu cost model of BMR suggests that prices are likely to be more sticky
when the MC curve is more elastic. In such a case the grey triangle will be
smaller, i.e. the profit gain is smaller from changing prices, so there is greater
incentive to stay at the current price rather than pay the menu cost. The flatness
of the MC is determined by so-called real rigidities, among which is included
the flatness of the WS curve.

2.4 Implications for the Phillips Curve

The BMR model leads to a flatter short-run Phillips Curve. If some firms do
not change prices to the optimal level then the aggregate price level will move
by less than if all firms are changing prices. In such a case the increase in output
will be accompanied by smaller increase in inflation. Or to take the case studied
above, the fall in aggregate output will be large as the firms who change prices
sell at y2 = y ∗ but those that don’t will only sell at y3 so total output will be,

yt = λy ∗ + (1 − λ) y3 (2)

where λ ∈ (0, 1) represents the fraction of firms changing their prices. Since
λ < 1 the total output change under sticky prices will be larger than under the
flexible prices.9 Now let us consider what happens to inflation. The aggregate
price level in the presence of sticky prices is given by,

pt = λp2 + (1 − λ) p1 (3)

where we note that p1 = pt−1 , i.e. it is the price level in the previous period.
We further denote the optimal price set by those firms choosing to change their
prices by p∗ , i.e. p2 = p∗ . So the aggregate price equation becomes,

pt = λp∗ + (1 − λ) pt−1 (4)

Since we are in log variables we have log-inflation as the difference between log-
prices in adjacent periods, i.e. πt = pt − pt−1 . So taking pt−1 from both sides
and re-writing in terms of inflation we get,

πt = λπt∗ (5)
9 Note that if λ = 1 then one is in the flexible price world

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where we have used pt−1 = λpt−1 + (1 − λ) pt−1 on the right hand side. The
term πt∗ = p∗ − pt−1 represents the change in inflation due to those firms that
change their prices. Since only a fraction of firms change their prices, the fall
in inflation will be less than under flexible prices. Thus there is a larger fall in
output and a smaller change in inflation, i.e. the Phillips Curve is flatter under
sticky prices than under flexible prices.

2.5 Other Models of Sticky Prices

There is no consensus on the micro-foundations of sticky prices in macroeco-
nomics. Some argue that in the internet age the menu cost of changing prices
is getting smaller, or even disappearing altogether. For example Amazon con-
stantly changes prices with no real menu cost as these are updated instan-
taneously online. However, even in this example one may argue that there
still exists a small menu cost associated with the implementation of such price
changes and the costs associated with the development of the optimal pricing
algorithm used by such online stores. Many also argue that most shops exist
both online and in physical premises so that the changing of prices online neces-
sitates changing of prices instore which then incurs a menu cost. While others
also argue that many small firms still exist only with physical stores that must
face the menu cost problem of BMR, however the detractors argue that as the
cost/complexity of e-commerce decreases such firms are only a small subset of
the total population of firms. So the debate around the importance of menu
costs continues with no solution likely in the near future.

Among the other micro-founded models of sticky prices, the most developed is
the staggered contracts model. This model contends that firms cannot change
certain contracts in response to a shock, e.g. wage contracts are negotiated
annually, production contracts for delivery of goods in the future unlikely to be
re-negotiated once signed. These contracts are often staggered in when they can
be re-negotiated. As such firms may not change prices immediately so that they
do not lose money on the contracts already signed. Once again, the detractors
to this literature point out that already signed contracts should be viewed as a
sunk cost, but behavioural studies suggest otherwise.

A final observation that many micro-founded models need to explain is the

apparent asymmetries in price changes. Wages are often downward rigid, i.e.
firms are generally unwilling to cut wages. Prices are upward rigid, i.e. firms
are more willing to cut prices than they are to raise them in response to a shock.

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3 The New Keynesian Phillips Curve
Despite the debate surrounding the micro-foundations of price stickiness, it is
an empirical fact in macroeconomics that nominal prices exhibit some degree of
inertia. That is we see in the data that both prices and inflation exhibit some
degree of stickiness. Rather than enter the debate on the micro-foundations
of sticky prices, macro models rely on a short hand approach to incorporating
sticky prices. That is macro models engineer sticky prices without modelling
the deeper causes of price stickiness at the micro level.

3.1 Macroeconomic Shorthand: The Calvo (1983) Model

and the New Keynesian Phillips Curve
The most common model used in the macro literature to incorporate sticky
prices is the Calvo (1983) staggered pricing model. In this model we assume
that each firm can freely re-set it’s price with probability λ, while with proba-
bility 1 − λ they will be stuck with their prices from the previous period.10 One
could consider λ as the probability that the firm is one of the BMR firms that
is in it’s re-pricing period.

Inflation is determined by those firms that have the opportunity to re-set their
prices, those not chosen must keep prices fixed hence their contribution to in-
flation is zero. This is exactly as studied for the BMR model above, i.e. if πt∗
is the inflation due to firms that get to change their prices in the given period
then the aggregate inflation rate is given by πt = λπt∗ .

The optimal price, p∗t , and hence optimal inflation is set to compensate for
expected general inflation and also take into account the output gap. This is
because if there is an output gap this has implications for the level of inflation
in the economy as given by the Phillips Curve. So the opitmal price will be a
function of Et πt + α (yt − ye ). In addition to this the Calvo mechanism makes
firms forward looking. The argument is as follows - in setting the price level at
πt∗ these firms must take into account the (1 − λ) probability that this price level
will define their price in period t + 1 if they cannot change prices, as such the
choice of πt∗ should therefore also take into account Et πt+1 + αEt (yt+1 − ye ).
10 One way to think about λ is to consider a ‘Calvo-fairy’ that wakes up between periods

and flies around visiting firms at random, and the fairy has no memory of the firms it visited
in previous periods. Those visited by the fairy wake up in the next period finding that they
can change their prices, while those not visited find that they cannot change their prices. As
the fairy cannot visit all firms given time constraints only some proportion of firms get to
change prices. Or equivalently there is some fixed probability of changing prices.

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Using similar logic we can deduce that the opitmal price level will be chosen as,
∞  i
X 1 i
πt∗ = (1 − λ) [Et πt+i + αEt (yt+i − ye )] (6)
i=0
1 + δ

where δ is the time discount rate to account for the fact that the future is not
as desired as the present. We now multiply both sides by λ and use πt = λπt∗
to re-write (6) as,

∞  i
X 1 i
πt = λ (1 − λ) [Et πt+i + αEt (yt+i − ye )] (7)
i=0
1 + δ

We now find πt+1 as the same form as (7),

∞  i
X 1 i
πt+1 =λ (1 − λ) [Et+1 πt+1+i + αEt+1 (yt+1+i − ye )] (8)
i=0
1 + δ

However we note that (8)

 isvalued at t + 1, not t so we must first of all multiply
1
through by a factor of 1+δ (1 − λ) so that it is valued at period t.11 Secondly,
if we are to compare at period t then we cannot use the acutal value of πt+1 but
rather what it was expected to be in period t, this requires taking the time-t
expectation of (8).Together these give,
  ∞  i+1
1 X 1 i+1
(1 − λ) Et (πt+1 ) = λ (1 − λ) [Et πt+1+i + αEt (yt+1+i − ye )]
1+δ i=0
1 + δ
(9)
where the expectations have changed from time-t + 1 expectations to time-t
expectations due to the Law of Iterated Expectations12 We then take (9)
11 This is to ensure we are comparing like-for-like in the sense of having values in the same

time period.
12 The Law of Iterated Expectations states that,

Et [Et+1 (Xt+2 )] = Et (Xt+2 ) (10)

The easiest way to see the intuition behind this result is to use days of the week, i.e. t =
Monday, t+2 = Tuesday, and t+3 = Wednesday. Then the term in the square brackets is what
you forecast on Tuesday the variable X will be on Wednesday. The whole term is what you
forecast on Monday for your Tuesday forecast of X on Wednesday. However, in order for your
expectation to be rational you must base all your expectations on the information you have on
Monday, i.e. what you expect on Monday the variable X will be on Wednesday. To see why
this is rational, consider if you expected on Monday that your information would change on
Tuesday, changing your expectation of the value X would take on Wednesday. Then rational
expectations will require you to take that into account on Monday otherwise it would not be
rational, i.e. at the date you know about it. Hence any information you have about Tuesday
for forecasting X on Wednesday is already reflected in the information you have on Monday.
Mathematically, the Law of Iterated Expectations says that when you take multiple
expectations in time order as is (10) then you can simplify it to become the expectation at
the earliest date since that is when all information will be rationally incorporated into the
forecast.

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away from (7) to get,
 
1
πt − (1 − λ) Et (πt+1 ) = λπt + λα (yt − ye ) (11)
1+δ

Now we can re-write this in terms of πt to get,

   
1 αλ
πt = Et (πt+1 ) + (yt − ye )
1+δ 1−λ
= Et (πt+1 ) + k (yt − ye )

where in the last line we have assumed δ = 0, i.e. no time discounting, and
αλ
defined k = 1−λ . Both of these equations are forms of the New Keynesian
Phillips Curve which play a central role in modern macroeconomic theory.

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