New Evidence On How Firms Set Prices

Price-setting is a central question of macroeconomic policy. But most existing models of pricing are inadequate. As a result, policy-makers pursuing inflation targets are often trying to control a variable whose behaviour they do not properly understand. That is the conclusion of Chris Martin of Brunel University, writing in the latest issue of the
Economic Journal. His research provides a number of important new insights into pricesetting in the UK:
• Prices depend both on domestic costs and world prices; a 10% increase in the price of goods produced abroad, or a 10% devaluation of sterling, will increase the price of UK goods by around 2.5%.
• The effect of the exchange rate on domestic prices is stronger than previously thought. Earlier models assume that exchange rates affect inflation because the retail price index reflects import prices (since people consume imports) and by affecting wages. Martin finds that the exchange rate also directly affects the prices set by UK firms. This reflects the effects of competition between domestic and foreign producers.
• The effects of policy changes may be felt more quickly than previously thought. Martin finds that half the effect of demand changes is felt within one year. Other work, using inadequate models of prices, predicts that less than 25% of the effect of demand changes is felt within the first year.
• Firms display sophisticated pricing behaviour. In particular, prices do not just depend on current and previous values of wages, productivity and demand. They also depend on expected future values of these variables. As a result, current prices anticipate future events.
• Despite evidence of sophisticated behaviour, Martin''s results also suggest that some prices are fixed for more than one year. The overall picture is very diverse: some firms adjust prices quickly while others keep prices fixed for considerable periods. Martin notes that the adoption of explicit inflation targets has meant that policy-makers
focus on the effects of policy changes on the inflation rate. Empirical models of pricing are an important part of this process and hence inadequate models of pricing may result in poor policy decisions. Martin''s findings may help explain why forecasts of inflation are often inaccurate. For example, economists were surprised by the swift reduction in inflation following sterling''s exit from the ERM in 1992. They were also surprised when inflation stayed close to its target level after 1992, despite forecasts of a rise.

''Price Formation in an Open Economy'' by Chris Martin is published in the Autumn
1997 issue of the Economic Journal. Subsequent, as yet unpublished work develops his
result further. Martin is Reader in Economics at the Department of Economics and Finance
Brunel University Uxbridge Middlesex UB8 3PH.