Economics Letters 41 (1993) 139-143 0165-1765/93/$06.00 1993 Elsevier Science Publishers B.V.

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139

Price adjustment and market structure

Christopher Martin
*

Department of Economics, Queen Mary and Wesrfield College, University of London, Mile End Road, London E1 4NS, UK
Received 1 September 1992 Accepted 29 September 1992

Abstract

This paper shows how the extent of price inertia depends on the form of market competition. We first establish that the speed of price adjustment depends on the curvature of the profit function in the region around the optimum price. We then show how this depends on market structure. We prove the following results: (1) the speed of price adjustment depends positively on the price elasticity of demand; (2) the speed of price adjustment depends positively on the number of firms in a market; and (3) the speed of price adjustment depends negatively on the degree of collusion between firms.

I. Introduction

Nominal rigidities in price setting were at the centre of early Keynesian models and have regained prominence with the emergence of New Keynesian Economics. The existence of widespread price inertia seems to be confirmed by a steady accumulation of empirical evidence at both the microeconomic and the macroeconomic level [see, inter alia, Carlton (1986), Alogoskoufis et al. (1990) and Gordon (1990)]. In addition, it is becoming apparent that the speed of price adjustment depends on imperfect competition. While no clear consensus has emerged, the balance of the evidence suggests that prices adjust more quickly in less concentrated industries [Carlton (1986, 1989), Encaoua and Geroski (1986), Hay and Morris (1991); but also see Domberger (1979)]. This paper seeks to explore the theoretical relationships between nominal inertia and market structure. We show how the speed of price adjustment depends on the second derivative, that is the curvature, of the profit function. We then show how this depends on market structure. We begin with monopolistic competition. We show that the speed of price adjustment increases as the elasticity of demand rises. This suggests that prices adjust more quickly more quickly in a more competitive environment. We then consider oligopolistic competition. We further show that prices adjust more slowly in more concentrated industries and that more collusive behaviour results in a slower rate of price adjustment. The structure of the paper is as follows. In section 2 we model price adjustment. In section 3 we relate the degree of nominal inertia to the degree of imperfect competition. Section 4 presents the results of a simple simulation that illustrates our results.

* I wish to thank Carlo Favero and Jonathan Haskel for some very helpful comments.

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C. M a r t i n / E c o n o m i c s Letters 41 (1993) 1 3 9 - 1 4 3

2. A d j u s t m e n t costs a n d s t i c k y prices

We suppose that the firm chooses a price of p but would choose a price p* in the absence of adjustment costs, where we assume that p* is exogenous. We also suppose the firm faces costs when it adjusts its price by more than p, where p can be related to the prevailing inflation rate [Layard et al. (1991)]. Total profit at time t is then given by V , = 1 r ( p , ) - O / 2 ( p , - p , l - p ) 2, where 7r(.) gives profit except for the effect of adjustment costs. We assume that firms choose their price to maximize the present value of the stream of future profits i 0 {rr(pt+i)--~(P,+i--P,+i _ p)2}

V=i~_oa

(1)

We proceed by expanding ~ ( p ) around p*. We can therefore write r r ( p ) = 7r(p*)+ (1/ 2)Tr"(p*)(p _ p , ) 2 , where rr"(p*) is the second derivative of 7r(p) evaluated at p*. In doing this, we have used the fact that ~"(p*) = 0 by definition. As a result, profit maximization is equivalent to the minimization of the following loss function:

A = ~ o.= s { ~ ( p , + 6

i --

*2 P,+i)

+ 20 ( P t + i -- P , + , - I

_p)2} ,

(2)

where q5 = +~'"(p*). Most analyses of price adjustment have started from a loss function similar to (2) [Rotemberg (1982a), Alogoskoufis et al. (1990) and Layard et al. (1991)]. 1 Our analysis shows how the weights on the loss function depend on the profit function. We might further expect that this will depend on the market structure in which the firm finds itself. Given (2), the price chosen by the firm can be shown to be
p,=Ap,_l+(1-A)(1
-

Aa)L
i=0

(aa) ip,+, + ,

a(1 -a)p
a(1 - a6 ) '

(3)

where the degree of sluggishness, A is given by the stable root of the equation

06A 2 - (fro + 0(1 + 8 ) )A + 0 = O .

(4)

This equations shows that the speed of price adjustment will depend on the curvature of the profit function through the term ~b. Since we can show that A decreasing in ~b, the greater is the second derivative of the profit function, the lesser is inertia. Thus, if a firm loses greatly by deviating from the optimal price, for example by pricing above marginal cost in a competitive market, the degree of curvature of the profit function will be substantial and as a result price adjustment will be swift. By contrast a firm whose profit function is flat close to the region around the optimal price will lose relatively little by not following the currently optimal price and so its price will exhibit more stickiness.

It is usual for the weight of the term (p - p * ) to be unity so that 0 represents the relative costs of price adjustment. See also Rotemberg (1982b).

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3. Market structure and price adjustment

In this section we will draw out the implications of these results using the familiar examples of monopolistic competition and oligopolistic behaviour.
3. I. M o n o p o l i s t i c competition

Considering monopolistic competition first, suppose that the firm has constant marginal cost and faces the demand curve
q = A p -~ .

(5)

Writing profits as A p *[p - M C ] , the slope of the profit function is given by

~'(p) = A p -~ 1 - e p p= Ap-'w .

(6)

Using the fact that o) = 0 at the optimal price p*, we can show that the second derivative of the profit function is simply 4' = (e - 1)Ap* (~+'). (7)

Since this is increasing in e, it follows that 6A/6~ < 0. The speed of price adjustment increases as the elasticity of demand rises. This establishes that prices adjust more quickly when firms have less market power to exploit.
3.2. Oligopoly

We now turn to the more general case of a firm in an oligopolistic industry. We suppose there are n identical firms in the industry, each producing an amount Yi. Each firm has constant marginal cost and conjectures that the output response of other firms to a change in its own output is y = d ( y - y i ) / d y i , where y is industry output. Finally, we suppose that the industry demand curve is again given by (5). It is a standard result that the ratio of price to marginal cost in this case is (1 - m ) -1, where m = k~(1 + y ) / e and ~ is the market share of each firm ]Cowling and Waterson (1976)]. Using these results, we can show that the second derivative of the profit function under oligopoly is given by & = e ( 1 - m ) A p *-(~+1)

(8)

Equation (8) simplifies to (7) if there is only one firm in the market. This result again shows that the speed of price adjustment increases with the price elasticity of industry demand. In addition, we see that prices adjust more quickly as the number of firms rises, since this reduces market share. We also see that the speed of adjustment depends on the firms' output conjecture, y. Cournot competition corresponds to Y = 0, while Bertrand competition in prices emerges if y = - 1 . We can see from this that price inertia rises as Y increases. Finally, we relate the conjectural variation term to collusive behaviour, following Clarke and Davies (1982). We suppose that the conjectural variation, y, can be expressed as y = ~ r ( 1 - P0/~. In this, the output response of other firms is assumed to depend on market shares. The degree of collusion is measured by ~r; if cr = 1 we have full collusion and so the output of each firm increases by the

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C. Martin / Economics Letters 41 (199,3) 139-143

Table 1 Results of simulations Value of e

n = l (1) 0.84 0.70 0.61 0.55 0.49 0.45 n = 2 (2) 0.77 0.64 0.57 0.52 0.46 0.43 n = 10

1.5 2.0 2.5 3.0 4.0 5.0

0.73 0.61 I).54 0.49 0.44 0.41

Notes:
(1) T a b l e 1 gives values of A for differing values of e and the number of firms (n). (2) The values of A were produced by calculating O from (9) and then finding the stable root of (4).

s a m e proportion; if cr = 0, w e have C o u r n o t behaviour. Substituting this e x p r e s s i o n for 3' into ( 8 ) , w e find that

qS=(E-/x-o-(1

tx))Ap* I,+~)

(9)

F r o m this w e derive the additional result that m o r e collusive behavi~ur tends to reduce the s p e e d of price adjustment.

4. Simulation results In order to illustrate these results w e c o n d u c t e d a simple simulation exercise. For a n u m b e r of values of the d e m a n d elasticity, E, and the n u m b e r of firms (n, the inverse o f / x ) , w e calculated the i m p l i e d value of A using (4) and (9). T h e results are p r e s e n t e d in Table 1. C o n s i d e r c o l u m n 1: this a s s u m e s the firm is a m o n o p o l y (n = 1) and s h o w s that 3, d e c r e a s e s from 0.84 to 0.45 as E i n c r e a s e s f r o m 1.5 to 5. T h e r e f o r e price inertia falls as the elasticity of d e m a n d increases. In c o l u m n s 2 and 3, w e repeat this exercise assuming that n = 2 and n = 10, respectively. W e see that price inertia falls as the n u m b e r of firms increases for each value of e. T h e s e results a s s u m e C o u r n o t c o m p e t i t i o n , so ~r = 0; w e also c o n d u c t e d e x p e r i m e n t s w h e r e tr varied. T h e s e s h o w e d that inertia rose w h e n collusion increased (we do not report the results but they are available f r o m the author). 2

References
Alogoskoufis, G . , C. Martin and N. Pittis, 1990, Pricing and product market structure in open economies, Discussion paper 221, Queen Mary and Westfield College. Carlton, D., 1986, The rigidity of prices, American Economic Review 76(4), 6 3 7 - 6 5 8 . Carlton, D., 1989, The theory and facts about how markets clear: Is industrial economics valuable for understanding m a c r o e c o n o m i c s , in: R. Schmalensee and R. Willig, eds., Handbook of industrial economics (North-Holland, Amsterdam). Clarke, R. and S. Davies 1982, Market structure and price-cost margins, E c o n o m i c a 49, 2 7 7 - 2 8 7 .
: In the simulations we also assumed 0 = 0.5. Marginal cost began with an initial value of 1, it then rose to 1.2.

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Cowling, K. and M. Waterson, 1976, Price-cost margins and market structure, Economica 43, 267-274. Domberger, S., 1979, Industrial structure, pricing and inflation (Martin Robertson, London). Encaoua, D. and P. Geroski, 1986, Price dynamics and competition in five OECD countries, OECD Economic Studies 6, 47-74. Gordon, R., 1990, What is New-Keynesian Economics?, Journal of Economic Literature. Hay, D. and D. Morris, 1991, Industrial economics and organisation: Theory and evidence (Oxford University Press, Oxford). Layard, R., S. Nickell and R. Jackman, 1991, Unemployment: Macroeconomic performance and the labour market (Oxford University Press, Oxford). Rotemberg, J., 1982a, Sticky prices in the United States, Journal of Political Economy 90(6), 1187-1211. Rotemberg, J., 1982b, Monopolistic price adjustment and aggregate output, Review of Economic Studies 46, 517-531.