Paralyzed by Fear: Rigid and Discrete Pricing under Demand Uncertainty

88 Pages Posted: 22 Aug 2019

See all articles by Cosmin Ilut

Cosmin Ilut

Duke University

Rosen Valchev

Boston College

Nicolas Vincent

HEC Montreal - Institute of Applied Economics

Date Written: February 5, 2019

Abstract

We propose a new theory of price rigidity based on firms’ Knightian uncertainty about their competitive environment. This uncertainty has two key implications. First, firms learn about the shape of their demand function from past observations of quantities sold. This learning gives rise to kinks in the expected profit function at previously observed prices, making those prices both sticky and more likely to reoccur. Second, uncertainty about the relationship between aggregate and industry-level inflation ensures nominal rigidity. We prove the main insights analytically and also quantify the effects of our mechanism. Our estimated quantitative model is consistent with a wide range of micro-level pricing facts that are typically challenging to match jointly, and implies significant monetary non-neutrality.

Suggested Citation

Ilut, Cosmin and Valchev, Rosen and Vincent, Nicolas, Paralyzed by Fear: Rigid and Discrete Pricing under Demand Uncertainty (February 5, 2019). Available at SSRN: https://ssrn.com/abstract=3439686 or http://dx.doi.org/10.2139/ssrn.3439686

Cosmin Ilut

Duke University ( email )

100 Fuqua Drive
Durham, NC 27708-0204
United States

Rosen Valchev (Contact Author)

Boston College ( email )

140 Commonwealth Avenue
Chestnut Hill, MA 02467
United States

Nicolas Vincent

HEC Montreal - Institute of Applied Economics ( email )

3000, ch. de la Côte-Ste-Catherine
Montréal, Quebec H3T 2A7
Canada

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