Even though prices are an essential part of the economy, surprisingly little effort goes into researching them or attempting to understand how they are set. The standard economics textbook gives only the briefest mention to the factors involved in their level. The standard summary is that prices are set in response to demand and supply. However, lately I’ve been thinking that this doesn’t quite make sense. The price of ice cream is the same in winter (a time of exceptionally low demand) as in summer (a time of exceptionally high demand). Pubs and restaurants usually charge the same prices during the day and mid-week (when they’re quiet) as during the night and on weekends (when they’re packed). In fact they seem to follow a policy of rationing space rather than allowing the price mechanism to adjust and convey information.
My epiphany came to me as I was wedged at the bar where I had been waiting for half an hour trying to order a drink during Black Monday. Why didn’t the student bar just raise its prices to deal with the excess demand which they knew would occur (as it did every year)? Why did they opt for an option that any first year economics student is taught is highly inefficient?
Another explanation is that prices are based on subjective value. However, this is simply circular logic. All it tells us is that the price is whatever the price is. If people are willing to pay $10, that’s the price, whereas if they are willing to pay $5 for the same good, then that is the price. The other favoured theory among microeconomists is that price equals marginal cost. However, this notion is treated as absurd by business people who recognise that marginal costs are only a small proportion of the total costs of a firm and if they were the basis for the price, the business would quickly go bankrupt.
So where does that leave us? Not for the first time, economic textbooks and neo-classical theory are no use in explaining how the real world actually operates. To fully understand how prices are set, we have to do something unthinkable. We have to ask business people themselves. The blogger Lord Keynes has done a fantastic job of compiling an impressive bibliography of how prices really are set (compilation available here). The evidence seems to support the Post-Keynesian theory of administered prices.
Research on the topic began during the Depression. In 1936, the Oxford Economists Research Group (OERG) conducted direct interviews with business people and discussed issues such as price setting. A gulf was found between how the economists imagined the business people acted and how they actually did. Economists were shocked to find that businessmen didn’t view prices as market clearing or even designed to do so.
“In fact severe questioning by the Group failed to uncover any evidence that the businessmen paid any attention to marginal revenue or costs in the sense defined by economic theory, and that they had only the vaguest ideas about anything remotely resembling their price elasticities of demand. The Oxford economists were shocked, to say the least. But what caught their attention even more was the relative stability of prices over the trade cycle, and this became the phenomenon which really needed to be explained.”
Businessmen were reluctant to change prices frequently as this was unpopular with consumers and would not lead to significant changes in sales. They made little or no effort to estimate the elasticity of their products. Businessmen felt that prices cuts would be matched by their competitors sparking a price war, whereas a price rise would not be matched. These two influences caused prices to be quite stable.
Fredric Lee’s Post Keynesian Price Theory provides a good explanation of how prices are really set. Lee examines over 100 empirical studies in his book to draw together a theory. The main finding is that prices are administered. That is to say, prices are set for a given period and left unchanged regardless of market conditions. The price is based on an estimate of costs plus a mark-up for profit. Businesses try to avoid price wars and direct competition, instead relying on advertising and sales promotions. Prices are far less responsive to market conditions than is often thought, but the desire to maintain consumer goodwill acts as a limited check on companies price setting power. If demand fell for a product, they are more likely to cut output or employment than to cut prices. Most industries have a “price leader” to which other companies base their prices. The stability of this system reduces uncertainty and allows businesses to make long term plans for investment.
This theory of administered prices goes against common beliefs on the free market. Rather than being driven purely by an invisible hand which uses competition to drive the best price for consumers and is highly responsive, administered prices suggest that private companies are just as subject to managerial dictates as government enterprises. In this sense there is nothing “unnatural” or “artificial” about government intervention in the economy or regulation of prices. Needless to say, this is a very controversial idea.
It should be clarified that there are two types of markets, fixprice and flexprice. In a flexprice market, prices are adjustable in response to supply and demand and the standard neo-classical story holds. In a fixprice market, prices are rigid and administered. The evidence shows that most markets are fixprice. In flexprice markets, changes in demand are met by changes in price, in fixprice markets they are met by changes in quantity. Rather than being profit maximisers, firms are aim to maximise sales and market share in order to expand.
Many business people contradicted the notion of a demand curve, arguing that changes in price had little or no effect on changes in sales. In order to have a significant effect on sales, prices would have to be cut to such an extent that businesses would suffer huge losses. Price changes are avoided where possible and only occur in response to changes in costs. Markets are therefore not clearing nor are firms profit maximising in the neo-classical sense. Administered prices reduce the level of uncertainty in the market and provide a degree of predictability. Instead of cutting prices to increase demand, businesses resort to advertising and build brand loyalty.
But what does the evidence say? Mainstream economists pay unfortunately little attention to price setting, usually taking it as given, but the few studies that have been done, all show that prices are set based on a mark-up of cost as suggest by Post-Keynesians, not set equal marginal cost as suggest by Neo-Classicals. Across the Eurozone, it is estimated that 60-70% of prices are administered, which is far higher than the number of prices set by the government which is only 18%. Marketing studies find further evidence. Studies found that between 70-85% of industrial companies did not rely on marginal cost but rather on mark-up pricing. They also found that managers couldn’t estimate the demand curve for their product, casting doubt on whether such a thing even exists.
In a survey of UK businesses, 58% said that prices were set by adding a mark-up onto cost and only 27% said prices were set by consumers. If there was a large increase in demand 74% of firms reported they would either increase overtime of workers or hire new workers, while only 12% said they would raise the price. In Ireland it was reported that 55% of prices were set by cost plus pricing, 33% in response to competitors and only 5% by consumers. Interestingly between half and three quarters (depending on the industry) of businesses reported that a negative demand shock would have little or no effect on the price. In New Zealand a survey of 5,300 firms found that 64% set their price based on costs plus profit, and 29% competition. It was found that the average firm reviewed its prices only twice a year but only changed them once a year. In an Australian survey of 700 firms, 49% said they set prices based on a mark-up of costs. 55% of firms said they changed prices one a year or less. Over half of Japanese firms reported a form of mark-up pricing. In Iceland too, mark-up pricing was the most prevalent form, representing almost half of firms. Demand was a poor explanation of price changing, as only 20% of price decreases and 7% of price increases were due to changes in demand. A survey of 725 Norwegian firms undertaken by the central bank found that 69% set prices based on mark-up to a significant degree. Nearly half of firms said they only changed their prices once a year with a further 23% only changing prices twice a year.
Across the world, there is a clear consensus that businesses set their prices according to adding a mark-up onto their costs. If anything they probably underestimate the prevalence of mark-up pricing as matching their competitor’s price would often be matching an administered price. What is interesting about the Norwegian survey was that firms were asked directly about whether or not they used mark-up pricing. As this resulted in a far higher response than other countries, it is probable that other countries use a higher degree of administered prices that gets labelled under following their competitors (who are in turn using administered prices). So little support was found for the neo-classical view that many businesses people didn’t even understand the concept of marginal cost that is standard in economic textbooks. It was also found that businesses tended to have constant or falling marginal costs rather than the rising ones common in textbooks. Menu costs, the standard New Keynesian explanation of price rigidity was dismissed by most businesses as irrelevant or of only minor importance.
A study by the former Vice Chairman of the Federal Reserve, Alan Blinder dealt further damage to Neo-Classical theory. He found that firms changed their prices infrequently, 72% changed it less than every quarter, with 45% changing it one a year or less. 89% of firms reported they had constant or declining marginal costs and 50% said they would not increase their prices when demand increased. Over half of the businesses described cost plus pricing as the most accurate description of their pricing policy. The vast majority of firms did not account for inflation in their price forecasts.
So prices are not as simple as supply and demand and once again Neo-Classical theory has been found to be in conflict with the real world. Instead, Post-Keynesians seem to be closest to the mark in their explanation of prices. This should cause a significant rethinking of the free market, away from viewing it as natural and self-adjusting. Instead it can be as rigid as the government it is often held in contrast to. An examination of how prices in the real world operate will contribute to helping to understand market inefficiencies and how to correct them. Prices do not come from an invisible hand or the wisdom of the market but are administered and fixed.