I’ve been reading an interesting little book, Price Setting by Truman Bewley. He did something that’s still quite unusual for economists (despite the excellent work by Stefanie Stantcheva): asking people what they think. In this case, it was asking hundreds of American businesses over a period of years how they set prices.
Most of the book consists of direct quotations from interviewees across a range of industries: manufactures, restaurants, construction, feed grains etc. Two types of price setting emerged. Sellers of highly differentiated products seldom cut prices, on the basis that demand is relatively inelastic, and it upset their customers too much to raise prices so better not to get into the position of needing to do so. Sellers of commoditised products vary prices substantially, but are increasingly turning to ‘formula based pricing’ such as indexation to a specific spot price or a price series published by trade organisations.
Nobody ever referred to monetary policy and the Fed. Nor did they talk about their decisions in terms of cost based pricing and stable marginal variable costs. Bewley states: “Marginal variable costs of manufacturing firms tend to remain constant or to decline as a function of output until capacity is reached, at which point marginal variable costs rise abruptly.” He calls this counterintuitive, although it doesn’t seem so to me, when you think about vintages of capital and capacity utilisation patterns.
In fact there’s a rather endearing tone in the book of a Martian explorer trying to explain humans to his fellow Martians in their own Martian language; businesses just don’t think in standard economic concepts so what they say needs translating. Similarly with productivity and no doubt other concepts too.
Although another way of thinking about it is that the margins economists assume are the important choice variables are not; other margins (quality, technology…) may be more important. When I was on the UK Competition Commission and we asked about price setting, the answer was almost always ‘what the market will bear’ and other variables preoccupied the management – although clearly this was a sample who found themselves in a competition inquiry.
Anyway, kudos to Truman Bewley for embarking on this interplanetary exploration. It’s the kind of book economists (including macro types) should read before they pick up their modelling pencils.
