Wednesday, July 14, 2010

Sticky expectations or just cheap

In an old post I thought that perhaps I had sticky expectations or that I was just cheap. But Nick Rowe explains that it is possible that I am not alone - that via comments by Richard Serlin, that consumers expect prices to be stable.

One of the arguments against sticky prices is that there are no microfoundations for this. Yet economists make all kinds of unrealistic assumptions all the time - sometimes with very little foundation - that agents are rational and utility maximizing or that preferences are Cobb Douglas or when it suits them, preferences are non-separable. Sometimes technology is Cobb-Douglas and sometimes it is CES again depending on which paper you are reading. These assumptions are all over the place and there is really no one set of assumptions that are made for all papers.

The argument for sticky prices posted above is that consumers do not like prices that change frequently. One of the hard things about economic modeling especially in dynamic models is the real world equivalent of a "period". In a model with 50 periods and prices that change every period can be considered "too frequent". The real world equivalent is usually a "quarter" or perhaps even a "month" - so are price changes every quarter really too frequent? Shoe prices that fluctuate every month I would consider to be too frequent, but if the price changes every quarter I can possibly deal with that.

One month ago, the price of a case of 18-pack Horizon Organic milk was $13.49 at our Giant grocery store nearby. Two weeks ago it was $13.99 and a few days ago it was $14.49. Is this too frequent? Again, it depends on the good as some papers have shown. (See yesterday's post and the links therein for references.) It also depends on whether these price changes will stick - i.e. is it worth my time to drive 10 or 20 minutes somewhere else to get it cheaper (or to find out that it is the same price!) Morever, where firms have the leeway to substitute for cheaper inputs or smaller portions (e.g. restaurants) they will do so.

To summarize, prices are sticky and models that explore price stickiness are a part of the development of economic knowledge. How important is this stickiness I am undecided. I am also unconviced that there is sufficient work done on the frequency of price changes and the possibility of substitutions - and I think it is because the data is not easy to come by. It is also not clear how consumers respond to price changes of various goods. In other words, a research agenda and hopefully enough grants to sustain a whole generation of economists.

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