Price Rigidity and Strategic Uncertainty

The phenomenon of infrequent price changes has troubled economists for decades. Intuitively one feels that for most price-setters there exists a range of inaction, i.e., a substantial measure of the states of the world, within which they do not wish to modify prevailing prices. Economists wishing to maintain rationality of price-setters resorted to fixed price adjustment costs as an explanation for price rigidity. This paper proposes an alternative explanation, without recourse to any sort of physical adjustment cost, by putting strategic interaction into the center-stage of the analysis. Price-making is treated as a repeated oligopoly game. The traditional analysis of these games cannot pinpoint any equilibrium as a reasonable “solution” of the strategic situation. Thus, decision-makers have a genuine strategic uncertainty about the strategies of other decision-makers. Hesitation may lead to inaction. To model this situation, the authors follow the style of agent-based models, by modeling firms that change their pricing strategies following an evolutionary algorithm. In addition to reproducing the known negative relationship between price rigidity and the level of general inflation, the model exhibits several features observed in real data. Moreover, most prices fall into the theoretical “range” without explicitly building this property into strategies.