Uncertainty, Production Lags, and Pricing
Abstract
Availability is an important attribute of a good in many markets. Such markets include retail stores, restaurants, hotels, manufacturing, taxi cabs, airlines, parks and public utilities. Some of these markets are competitive, some noncompetitive, and some regulated. Fluctuating delivery time can be thought of as the consumers' equivalent to varying availability of a good. Here too, customers face some risk of being unable to obtain goods when they want them. There are good reasons why some markets do not always clear in the classical supply and demand sense at each instant. The three features that characterize these markets are temporary price inflexibility, demand uncertainty, and production lags. Prices do not instantaneously adjust in response to shifts in demand. If demand is especially heavy during the moming, prices do not rise in the aftemoon. Several justifications for such temporary price inflexibility are possible. Consumers may dislike price fluctuations, and firms may be providing a service of stabilizing prices in the very short run. Changing price may be costly. To provide an effective signal, prices may have to remain fixed for some time period. Unless it is evident that demand and supply have permanently shifted, firms may be reluctant to change price. Whatever the reason, it is a fact that for many markets, price once set does not vary for some time. Of course, there still remains the issue of how the price is initially determined. The second feature of these markets is that demand is uncertain. If demand were perfectly predictable, there would be no need to have unsatisfied customers. The final feature is that production takes time. If instantaneous production were possible, once again there need be no unsatisfied customers. We assume that recontracting or insurance markets do not develop. Such markets rarely develop in reality presumably because of high transaction and monitoring costs. This paper discusses the implications of markets characterized by price inflexibility, demand uncertainty over the time period for which prices are inflexible, and noninstantaneous production. A competitive equilibrium is defined and its properties examined. The social welfare implications of these markets and the socially optimal policy and its relation to regulation are analyzed. This social welfare problem is exactly the same as a peak load pricing problem under uncertainty. We next deal with the behavior of a monopolist, who tends to oversupply availability, but whose behavior is consistent with a smoothly functioning economy. Finally, the issue of firm interaction and incentives for vertical integration is addressed.
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