Market power and cyclical pricing: The macroeconomic implications of industrial organization

This dissertation attempts to advance our understanding of price dynamics by investigating how prices adjust following a change in demand. Previous work has the common feature of an equilibrium that supports collusion among firms. A new explanation based upon the private incentives of unilateral market power is offered for sluggish or countercyclical price adjustment. After discussing the theoretical and empirical literature on the cyclical nature of prices and price-cost margins in chapter one, the next three chapters develop and test the market power model. The second chapter examines the short-run version of the model. The market power of firms changes with the business cycle, and this affects the cyclical pricing behavior of firms. Following a decrease in demand in the short-run, capacity-constrained firms all choosing a market clearing price as a best response may have a strong incentive not to lower their prices to the new competitive price. Experimental markets with complete information convincingly support the conjecture that unilateral market power is a source of countercyclical markups. This short-run market power model of cyclical pricing is then extended in chapter three to a long-run framework. In the long-run version of the market power model, duopolists simultaneously choose capacity with an uncertain demand in the first stage. Once capacity is chosen, the demand is revealed to the firms and they compete in prices. The fourth chapter tests the unique implications of the market power model with a time series field study. The market power model predicts that real price changes are drawn from a distribution with a high variance when output concurrently is in a contractionary state, but from a low variance when output is in an expansionary state. The evidence is consistent with the unique prediction of the market power model. Chapter five explores other explanations for sluggish price adjustment which have received considerable theoretical attention in macroeconomics, but which have been subjected to limited direct testing. This chapter uses experimental economies to test how menu costs and their interactions with potentially rigid factor costs affect product price adjustment