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Paralyzed by Fear: Rigid and Discrete Pricing under Demand Uncertainty

Author

Listed:
  • Cosmin Ilut

    (Duke University)

  • Rosen Valchev

    (Boston College)

  • Nicolas Vincent

    (HEC Montreal)

Abstract
Price rigidity is central to many predictions of modern macroeconomic models, yet, standard models are at odds with certain robust empirical facts from micro price datasets. We propose a new, parsimonious theory of price rigidity, built around the idea of demand uncertainty, that is consistent with a number of salient micro facts. In the model, the monopolistic firm faces Knightian uncertainty about its competitive environment, which has two key implications. First, the firm is uncertain about the shape of its demand function, and learns about it from past observations of quantities sold. This leads to kinks in the expected profit function at previously observed prices, which act as endogenous costs of changing prices and generate price stickiness and a discrete price distribution. Second, the firm is uncertain about how aggregate prices relate to the prices of its direct competitors, and the resulting robust pricing decision makes our rigidity nominal in nature.

Suggested Citation

  • Cosmin Ilut & Rosen Valchev & Nicolas Vincent, 2016. "Paralyzed by Fear: Rigid and Discrete Pricing under Demand Uncertainty," Boston College Working Papers in Economics 940, Boston College Department of Economics.
    • Handle: RePEc:boc:bocoec:940
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    References listed on IDEAS

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    More about this item

    Keywords

    price rigidity; demand uncertainty;

    JEL classification:

    • C1 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General
    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles
    • L11 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Production, Pricing, and Market Structure; Size Distribution of Firms

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