Price-Setting under Uncertain Deman d: 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 p
roducts change prices twice as often as the average product. Second, the av
erage size of these adjustments is at least 50 percent larger than the aver
age price change. We argue that a menu cost model with price experimentatio
n can rationalize these findings. The firm is uncertain about its demand el
asticity under this setting, but can experiment with its price to endogenou
sly affect its posterior beliefs which are updated in a Bayesian fashion. A
s a result, firms face the trade-off between increasing the speed of learni
ng 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 a
n unanticipated monetary shock is 40 percent larger than in Golosov and Luc
as (2007). On impact, selection is weakened as the experimentation motive a
lters the distribution of desired price changes and decreases the fraction
of firms near the margin of adjustment. Furthermore, the notion of a produc
t’s life-cycle generates an additional form of cross-sectional heterogeneit
y in the frequency of price adjustment. This causes the monetary shock to b
e further propagated.