Price-Setting under Uncertain Demand: A Menu Cost Model with Price Experimentation

Abstract:
We document a new set of salient facts on the pricing moments over the life-cycle of U.S. products. First, entering products change prices twice as often as the average product. Second, the average size of these adjustments is at least 50 percent larger than the average price change. We argue that a menu cost model with price experimentation can rationalize these findings. The firm is uncertain about its demand elasticity under this setting, but can experiment with its price to endogenously affect its posterior beliefs which are updated in a Bayesian fashion. As a result, firms face the trade-off between increasing the speed of learning through price experimentation and maximizing their static profits. This mechanism can endogenously generate large price changes, without the use of fat-tailed idiosyncratic shocks, and can replicate the life-cycle patterns we document. We show quantitatively that the cumulative output effect of an unanticipated monetary shock is 40 percent larger than in Golosov and Lucas (2007). On impact, selection is weakened as the experimentation motive alters the distribution of desired price changes and decreases the fraction of firms near the margin of adjustment. Furthermore, the notion of a product’s life-cycle generates an additional form of cross-sectional heterogeneity in the frequency of price adjustment. This causes the monetary shock to be further propagated.