Sticky prices, coordination and enforcement

John Driscoll and Harumi Ito

No 2003-30, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

Abstract: Price-setting models with monopolistic competition and costs of changing prices exhibit coordination failure: In response to a monetary policy shock, individual agents lack incentives to change prices even when it would be Pareto-improving if all agents did so. The potential welfare gains are in part evaluated relative to a benchmark equilibrium of perfect, costless coordination; in practice, since agents will still have incentives to deviate from the benchmark equilibrium, coordination is likely to require enforcement. We consider an alternative benchmark equilibrium in which coordination is enforced by punishing deviators. This is formally equivalent to modeling agents as a cartel playing a punishment game. We show that this new benchmark implies that the welfare losses from coordination failure are smaller. Moreover, at the new benchmark equilibrium, prices are upwards-flexible but downwards-sticky. These last results suggest that the dynamic behavior of sticky-price models may more generally depend on the kind of imperfect competition assumed.

Keywords: Monopolistic competition; Prices (search for similar items in EconPapers)
Date: 2003
New Economics Papers: this item is included in nep-ind
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Journal Article: Sticky Prices, Coordination and Enforcement (2003)
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