Simple demand/supply theory focuses strictly on price as the allocation mechanism. Given stable demand curves, firms sell more when they reduce prices, less when they raise them. If markets are perfect, firms have no leeway: they must charge the competitive equilibrium price.
However, in the real world, consumers are interested in more than price. They are interested in quality of product and of service and, in a world of costly information, they are interested in consistent pricing policies that minimize the need to search for price information.
When characteristics other than price matter, markets are highly competitive but not, according to economic terminology, perfectly competitive. In particular, individual firms can affect their sales by setting prices. Firms that sell higher-quality goods or that provide higher-quality service can charge higher prices and still maximize profits. Other firms may take a minimal service/low price tack.
In a world full of monopolistic competitors, firms must be careful in their pricing strategies. In particular, raising prices to exploit a temporary increase in demand may lead to a permanent loss of customers.
For example, an increase in the demand for, say, cellular telephones, if met by one company raising prices while other companies backlog orders, may cost the first company dearly in the long run.
A. Customer markets
Markets that clear solely through price movements are called auction markets. The simple demand/supply examples we examined early in the semester are really auction-market examples. But most of us do little shopping in auction markets. Instead, we buy from stores that set prices, keeping them constant for weeks or months at a time. In the long run, prices must clear the market. But in the short run, firms are willing to accumulate or decumulate inventories, while holding prices constant.
In customer markets firms leave prices constant for extended periods and compete on nonprice bases. Why do firms behave in such a manner?
Perhaps the most important reason for price stickiness is that customers expect it. Price information is not costless. Most people shop repeatedly for particular types of goods at particular stores, having found through experience that these stores have the best prices.
Busy customers don't have time to make a complete survey of prices every time they buy a good, unless the good is quite expensive (e.g., a car). Therefore, stores reduce search costs by maintaining stable prices.
Customers tend to continue returning to particular stores so long as they are satisfied with the prices. They may occasionally sample the prices in other stores to make sure they are still getting a good deal, but in general, so long as they are satisfied, they continue their patterns of shopping.
Such behavior makes firms reluctant to change prices, either up or down. Why lower prices if customers are satisfied? Why raise them if they run the risk of making customers dissatisfied?
A second reason for infrequent price changes is that, for some firms at least, changing prices is costly. Firms that issue large catalogs (e.g., J.C. Penney) must fix prices for months at a time - although they may run sales on some goods in the interim. Even changing price lists and advising sales representatives imposes some costs.
But firms do raise prices. Why? Firms raise prices when they are confident that such price increases will not harm their competitive positions. And when is this? When they are sure that competitors will also raise their prices.
B. Cost-based pricing and the transmission of inflation
When a firm faces increased demand for its product, it doesn't know whether the increase is permanent or temporary or whether it is specific to the firm or generalized across all firms in the industry. In short, the firm is uncertain how its competitors will react.
However, when input costs increase, the firm is generally sure that competing firms are also facing higher costs - and lower profits. Even in the face of rising input costs, firms may be reluctant to be the first to increase product prices. But once one firm raises its price, others typically follow quickly.
This leads to a pattern of cost and price increases. Let's work through a simple example.
(1) Suppose aggregate demand increases, increasing the demand for products in most markets. At the retail level, firms respond by selling more at constant prices. If they are unable to meet demand, they will place backorders for customers.
(2) The demand increase is passed through to wholesalers, who behave similarly.
(3) Manufacturers next feel the increase. Studies have shown that marginal cost is relatively constant over wide output ranges, so again prices may change little.
(4) Manufacturers pass the demand along to factor markets. The demand for raw materials and for labor increases. Factor prices rise, since more inputs can be obtained only at higher prices.
(5) Higher input prices are transmitted to manufactuers, who increase their product prices.
(6) Wholesalers respond by raising wholesale prices.
(7) Finally, retailers react to higher wholesale prices by raising the prices customers must pay.
The entire process of aggregate demand increase to resulting increase in the price level takes considerable time. Costs must rise before prices increase. Note two things, however:
(1) The initiating force was an increase in aggregate demand. Cost increases are not the real problem.
(2) Since labor is the major input in aggregate production, the labor market is the key factor market in the inflation-transmission process.
Now that we have discussed the underpinnings of the short-run model, let's see how it works in response to various shocks.
A. Business optimism triggers a surge of investment
A surge of investment spending increases aggregate demand, shifting the AD curve to the right. If the new equilibrium output level is below the natural output level, then the increase in real GDP is the end of the story.
What if, however, the increase in AD increases Y beyond the natural level. If this happens, the unemployment rate falls below the natural rate - and pressure for wage increases builds. When these wage increases occur, production costs increase, and firms pass through the higher costs in the form of higher prices. Graphically, the SRAS curve shifts upward. The price level rises and (AD constant) Y declines toward the natural level. The process of wage and price increases continues until output has fallen (and unemployment has risen) to its natural level.
B. Pessimism drives investment down
A decrease in investment spending shifts the AD curve to the left. Y decreases. But even if Y falls below Yn, prices are not likely to fall anytime soon. Why? Because wage are particularly sticky downward. Even though u is above un, the vast majority of firms will resist wage cuts. Therefore, the economy will tend to stay in a low-output position until aggregate demand begins to rise again.
Government policymakers can encourage AD growth through various means. Most likely, the Federal Reserve will use its monetary powers to reduce interest rates, thereby encouraging interest-sensitive spending. Fortunately, the U.S. economy typically rebounds rather quickly, even if policymakers do little to increase AD.
***