PRICE RIGIDITY: New evidence that dominant firms are slow to adjust their prices (even upwards!) when costs change

Firms with market power delay changing their prices following a cost change, while more competitive firms do not. That is the central finding of Joshua Sherman and Avi Weiss in an analysis of detailed daily data from Shuk Mahane Yehuda, the outdoor retail market in Jerusalem and one of the largest such markets in Israel.

Previous research has suggested that ''price rigidity'' only occurs when costs go down. But the new study, which is published in the December 2015 issue of the Economic Journal, shows that this also may be true when costs rise. Surprisingly, firms with market power delay their price increases as well as their price reductions.

The issue of price rigidity has concerned economists for almost a century. But until now, researchers have typically focused on the downward price rigidities of firms with market power.

The new study compares predictions from a theoretical model based on the structure of Shuk Mahane Yehuda with the results of an empirical analysis of price responses to changes in cost, which were collected daily at the market over a four-month period.

The researchers find that firms with localised market power exhibit both downward and upward price rigidity in response to changes in cost, whereas firms that face immediate competition do not exhibit such rigidity.

Sherman and Weiss attribute this phenomenon to short-term ''information asymmetries'' between consumers and firms. What this means is that when a consumer cannot infer or know a firm''s current costs with certainty, she will be charged the expected price of a more competitive firm plus the cost that she must incur to travel to the alternative firm. Therefore, downward and upward price rigidity is a natural consequence of the fact that the firm''s current price is independent of the firm''s current costs.

The fact that previous empirical studies have not yielded similar results may be attributable to two factors. First, a key ingredient for bi-directional price rigidity is the difference in intensity of a given firm''s competitive environment relative to that of its competitors. Without accounting for such differences, it is less likely that such price rigidity would be detected empirically.

The second factor relates to the difficulties associated with finding and collecting high frequency price and cost data. The researchers speculate that rigidities associated with short-term information asymmetries between consumers and firms in certain environments may not be detected using weekly or monthly data. But the increasing availability of high frequency data should allow for further studies in the future.

''Price Response, Asymmetric Information and Competition'' by Joshua Sherman and Avi Weiss is published in the December 2015 issue of the Economic Journal. Joshua Sherman is at the University of Vienna. Avi Weiss is at Bar-Ilan University.