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.
Alan Blinder conducted a survey of firms asking similar questions and getting similar answers. I mentioned it in my paper on the math of profit maximization.
https://www.paecon.net/PAEReview/issue99/George99.pdf
Yes, it’s discussed in the intro to this book. Thank you for the link.
Diane
It has important implications for economic theory. I show that the idea that marginal cost increases with demand is incorrect. And the roots of this incorrect belief lie in the theory of profit maximization.
Variable costs are determined by the supplers of a firm. Why should they fall according to the output of a firm until capacity is reached? It is the marginal cost which falls with output, not the marginal variable cost. The error that neoclassical economists is to assume that marginal cost and marginal variable cost are equal. They are not until the fixed investment cost has been fully recovered.
Interesting. At one time (but it went nowhere because my actual job got too busy) I was interested in how being publicly owned or regulated influenced the pricing of public transport operators. To do that I needed to compare their pricing with what it would have been under straight competition. But I could not find any useful concrete answer to that question.
At another time I wanted to know how the promotion of renewable energy (eg biofuels, which were my actual job) would affect the pricing of alternatives (eg petrol and diesel). It seemed to me that those prices would fall and that was part of the benefit of promoting the alternatives. Problem was that petrol and diesel pricing is by oligopolists. I argued in vain that in pure competition, less demand means lower prices; in monopoly, less demand means lower prices (though the book you review suggests otherwise); it is reasonable to assume that the same would be true under oligopoly. I could not get the modellers to include this offsetting benefit to the cost of promoting (then) more-expensive renewables.
Conclusion: policy-makers need economists to tell us more and better about price setting.
(I don’t mean that we need economists who will tell us that our policies are right – just that in this respect they aren’t helping us to tell, either way.