Sources of differential relative price variability: An examination of the microfoundations of inflation

The central issue dividing neoclassical and Keynesian economists is how markets react to perturbations to longrun equilibria. The standard resolution of this controversy is that neoclassical responses are appropriate to competitive markets, while Keynesian responses better describe oligopolistic markets.The past few years have seen emphasis return to the microfoundations of Keynesian economics of inflation from the labor to product markets. A number of arguments have been advanced to explain differences in shortrun relative price variability across markets. Four of these are examined in this dissertation. J. R. Hicks' fixprice-flexprice framework attributed increased relative price variability to the presence in certain markets of traders who hold/discharge large speculative stocks of the relevant goods. Arthur Okun, using an auction-customer market dichotomy argued that relative price inflexibility arises in markets which display characteristics of implicit contracts via customer-seller relations. This feature diminishes the need for price adjustment to influence the marginal customer. Tibor Scitovsky stressed the importance of market power in both goods and labor markets with respect to price making behavior. Firms in concentrated industries/labor unions have the ability to keep market price/wage insulated from shortrun changes in demand. Finally, Frank Shupp has suggested that the degree of relative price variability is linked to the variable-factor intensity of the production process. This follows because with a greater variable-factor content, price cuts designed to spur demand are just not profitable if they result in higher variable costs.While each of these hypotheses claims some merit, none has been empirically tested. The purpose of this thesis is to do that, and hence, to study the degree to which each is valid.The Kalman Filter is used to decompose price movements in 2- and 3-digit SIC industries into permanent and transient components. As first approximations, variances of the transient components are used to construct measure of relative price variability. These measures are then examined against proxies for each of the four arguments presented above to study their comparative validity.U of I OnlyETDs are only available to UIUC Users without author permissio