Knowledge that Transforms

To make high-quality research more accessible and easier to explore.

1646 results ✕ Clear filters

Output and Welfare Effects of Inflation with Costly Price and Quantity Adjustments

Leif Danziger
American Economic Review 2001 91(5), 1608-1620
There exists by now a burgeoning literature concerned with the consequences of a fixed cost of price adjustment. Due to this cost, a monopolistic firm does not necessarily adjust its price even though the current price deviates from the price that would maximize the firm's current profit. As a result, the production generally differs from what it would be in the absence of a menu cost, with the effect of inflation on the average output and welfare under monopolistic competition being ambiguous and depending in a complicated way on the profit and demand functions. 1 However, one strong result holds unambiguously for all profit and demand functions: at low inflation rates, the average output and welfare are above their levels at full price stability where firms charge the static monopoly price.2 The driving force is that discounting makes a firm more concerned with its real profits earlier in a period with a constant nominal price than with its real profits later in the period. In fact, as the inflation rate approaches zero, the firm's initial real price converges to the profit-maximizing real price, while the terminal real price converges to a smaller real price. At low inflation rates, therefore, a firm's price is most of the time below the price that would maximize the current profit. Since output and welfare under monopolistic competition are inversely related to price, average output and welfare are higher than under full price stability. The inevitable conclusion is that the economy benefits from a little bit of inflation. A critical assumption underlying this result is that firms can continuously adjust their production to satisfy demand. So while the menu-cost literature explicitly assumes that there is a small fixed cost incurred at each price adjustment, it also implicitly assumes that it is costless to continuously adjust the quantity of output.3 This is, however, a questionable assumption. There is some empirical evidence indicating the existence of a cost of quantity adjustment, part of which is fixed in that it does not depend on the size of the adjustment.4 The cost of quantity adjustment stems from the need to rearrange and reorganize the factor inputs for the new level of production and includes managerial time and effort. A fixed cost of quantity adjustment rules out any continuous adjustment of the production to satisfy the increasing demand that results from a decreasing real price within a period with a constant nominal price. Under the reasonable assumption that the menu cost does not exceed the fixed cost of quantity adjustment,5 in an inflationary environment a firm chooses to adjust its nomi-

Reversing the Keynesian Asymmetry

John Bennett; Manfredi M. A. La Manna
American Economic Review 2001 91(5), 1556-1563 open access
The assumption that nominal price adjustment is costly for firms (there are "menu costs") has generated a stream of important theoretical papers over the last decade or so. 1 In so far as this literature generates asymmetric adjustments, it provides a theoretical underpinning for the (old)Keynesian assumption that nominal prices are more flexible upward than downward. 2Yet, the empirical evidence, while confirming that asymmetri es exist, does not indicate the dominance of any particular form of asymmetry (see Dennis W. Carlton, 1986; Alan S. Blinder, 1991).In this paper we argue that the gap between theory and practice may be the result of the focus of menucost models on specific forms of market structure.Existing menu -cost models are based on the assumption of relatively uncompetitive market structures -monopoly, oligopoly, or monopolistic competition with a fixed number of firms.We widen the scope of the analysis by examining what we call a quasi-competitive industry and demonstrate that it displays a pattern of adjustment quite different from that found in other models.The Keynesian asymmetry is reversed, with nominal price being more flexible downward than upward. 3 We suggest therefore that a relationship exists between market structure and the pattern of nominal price adjustment.Since there is presumably a variety of market structures, this may help explain the inconclusive empirical evidence.We model the most competitive market configuration compatible with menu costs:Bertrand oligopoly in a dynamic setting with free entry.It is assumed that (a) an incumbent in one period can continue to sell at its existing nominal price in the next period without incurring any additional menu cost, whereas an entrant would have to incur a menu cost; and (b) among the firms willing to sell at the lowest price in any given period, one is chosen randomly to sell the

Social Culture and Economic Performance

Hanming Fang
American Economic Review 2001 91(4), 924-937
The connection between obtaining higher paying jobs and undertaking some seemingly irrelevant activity is interpreted as “social culture.” In the context of a society trying to adopt a new technology, I show that by allowing the firms to give preferential treatment to workers based on some “cultural activity,” the society can partially overcome an informational free-riding problem. Therefore, social culture may affect the economic performance by altering the effective production technology of the economy. (JEL P17, Z13)