NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Paralyzed by Fear: Rigid and Discrete Pricing under Demand Uncertainty

Cosmin L. Ilut, Rosen Valchev, Nicolas Vincent

NBER Working Paper No. 22490
Issued in August 2016
NBER Program(s):Economic Fluctuations and Growth, Industrial Organization, Monetary Economics

Price rigidity is central to many predictions of modern macroeconomic models, yet, standard models are at odds with certain robust empirical facts from micro price datasets. We propose a new, parsimonious theory of price rigidity, built around the idea of demand uncertainty, that is consistent with a number of salient micro facts. In the model, the monopolistic firm faces Knightian uncertainty about its competitive environment, which has two key implications. First, the firm is uncertain about the shape of its demand function, and learns about it from past observations of quantities sold. This leads to kinks in the expected profit function at previously observed prices, which act as endogenous costs of changing prices and generate price stickiness and a discrete price distribution. Second, the firm is uncertain about how aggregate prices relate to the prices of its direct competitors, and the resulting robust pricing decision makes our rigidity nominal in nature.

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Document Object Identifier (DOI): 10.3386/w22490

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