Optimal Price Setting with Observation and Menu Costs

82 Pages Posted: 29 Mar 2010

See all articles by Fernando Alvarez

Fernando Alvarez

University of Chicago - Department of Economics; National Bureau of Economic Research (NBER)

Francesco Lippi

Università degli Studi di Sassari; Einaudi Institute for Economics and Finance (EIEF)

Luigi Paciello

Einaudi Institute for Economics and Finance (EIEF)

Multiple version iconThere are 2 versions of this paper

Date Written: March 2010

Abstract

We model the optimal price setting problem of a firm in the presence of both information and menu costs. In this problem the firm optimally decides when to collect costly information on the adequacy of its price, an activity which we refer to as a price "review". Upon each review, the firm chooses whether to adjust its price, subject to a menu cost, and when to conduct the next price review. This behavior is consistent with recent survey evidence documenting that firms revise prices infrequently and that only a few price revisions yield a price adjustment. The goal of the paper is to study how the firm's choices map into several observable statistics, depending on the level and relative magnitude of the information vs the menu cost. The observable statistics are: the frequency of price reviews, the frequency of price adjustments, the size-distribution of price adjustments, and the shape of the hazard rate of price adjustments. We provide an analytical characterization of the firm decisions and a mapping from the structural parameters to the observable statistics. We compare these statistics with the ones obtained for the models with only one type of cost. The predictions of the model can, with suitable data, be used to quantify the importance of the menu cost vs. the information cost. We also consider a version of the model where several price adjustment are allowed between observations, a form of price plans or indexation. We find that no indexation is optimal for small inflation rates.

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Suggested Citation

Alvarez, Fernando and Lippi, Francesco and Paciello, Luigi, Optimal Price Setting with Observation and Menu Costs (March 2010). NBER Working Paper No. w15852, Available at SSRN: https://ssrn.com/abstract=1578689

Fernando Alvarez (Contact Author)

University of Chicago - Department of Economics ( email )

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Francesco Lippi

Università degli Studi di Sassari ( email )

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Einaudi Institute for Economics and Finance (EIEF) ( email )

Via Due Macelli, 73
Rome, 00187
Italy

Luigi Paciello

Einaudi Institute for Economics and Finance (EIEF) ( email )

Via Due Macelli, 73
Rome, 00187
Italy

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