Yes, prices are sticky in Europe

Who would have thought that a survey of European firms conducted by nine central banks would discredit the law of one price and bolster New Keynesian theories of price stickiness? But that's what Eurozone central bank economists have found. More than 11,000 firms participated in national surveys in 2003 and 2004 in nine Eurozone countries (Austria, Belgium, France, Germany, Italy, Luxembourg, the Netherlands, Portugal and Spain), covering 94% of euro area GDP.

For some time now, members of the Eurosystem Inflation Persistence Network (EIPN) have been gathering date and presenting papers. They are nothing if not industrious. A December 2004 two-day conference in Frankfurt, Inflation Persistence in the Euro Area, saw an impressive 19 papers and 42 background papers.

Now the ECB and national central banks have published their synthesis of findings from the nine surveys. A new working paper, The pricing behaviour of firms in the Euro area: new survey evidence (PDF), provides a comprehensive empirical overview of price setting in the Eurozone. Here are the main findings:

The results are very robust across countries. Firms operate in monopolistically competitive markets, where prices are mostly set following mark-up rules and where price discrimination is a common practice. Our evidence suggests that both time- and state-dependent pricing strategies are applied by firms in the euro area: around one-third of the companies follow mainly time-dependent pricing rules while two-thirds use pricing rules with some element of state-dependence.

Although the majority of firms take into account a wide range of information, including past and expected economic developments, about one-third adopts a purely backward-looking behaviour. The pattern of results lends support to the recent wave of estimations of hybrid versions of the New Keynesian Phillips Curve. Price stickiness arises both at the stage when firms review their prices and again when they actually change prices. The most relevant factors underlying price rigidity are customer relationships - as expressed in the theories about explicit and implicit contracts - and thus, are mainly found at the price changing (second) stage of the price adjustment process.

Finally, we provide evidence that firms adjust prices asymmetrically in response to shocks, depending on the direction of the adjustment and the source of the shock: while cost shocks have a greater impact when prices have to be raised than when they have to be reduced, reductions in demand are more likely to induce a price change than increases in demand.

With mark-up pricing "the dominant price setting practice adopted by firms in the euro area" and price discrimination "a common practice", the authors conclude:

...the model of perfect competition with the law of one price does not seem to be the blue print for most of the goods and service markets in the euro area.  This also suggests that models with monopolistic competition, like New Keynesian models, may be a better description for most goods and service markets than those that assume perfect competition.

That's not what most of us we told in our economics courses. Time to start revising those textbooks, I'd say.

Comments

[Tim Worstall]

Why is this so surprising? Every businessman in the world spends his entire time trying to differentiate his product so as to be able to price monopolistically. What doesanyone think branding or advertising budgets are for?

[AJE]

"Time to start revising those textbooks, I'd say."

Defo. Let's start using the word "entrepreneurship", and view the market as a process.

[Angry Economist]

But if you read some textbooks specifically on public sector economics, and the economics of market failure they always say "in reality, markets rarely function perfectly". As we know, there are not so many examples of PC markets. Most markets work imperfectly - information asymmetries, monopolies, externalities, temporal lags in market/price adjustments etc. The big question is, is their imperfectness a big big problem or issue, or is it at an acceptable level? and then, can we do anything about it if it is a problem?

Not so much a case of rewriting text books but referring to the right ones...

[AJE]

"The big question is, is their imperfectness a big big problem or issue, or is it at an acceptable level? and then, can we do anything about it if it is a problem?"

Bullshit - the question should be "do I have the right model?"

What is a "perfectly functioning market" - according to your theory it's one without any trading. That should strike anyone with half a brain as being nonsense. Perfect competition was never intended to be a realisable goal: it's a thought experiment, utterly unattainable and thankfully so.

I think a far better way of viewing an economy is as a system of exchange, and the institutions through which exchange occurs, rather than a giant machine susceptable to the will of Mr Central Planner.

[Angry Economist]

AJE,

Well I agree with you to some degree for what its worth. In government thinking, and policy making we are landed with an idealised perfectly competitive model, especially in the way the government thinks about the world, and as you say, the PC market model is very flawed.

Many market Failure theories et all deal with this, but most tend to deal with this still within the classical model or PC market model.

As for the rest of your comments about my theory, me being Mr. Central Planner etc, your putting words into my mouth there or reading between lines that don't exist. I really view market models as imperfect tools for understanding how the economy works or doesn't. No different to most sensible economists I'll bet. I don't put so much stock in them as to remove common sense from operating from my full or half brain as you put it.

My big point is that ok, markets don't work to perfectly competitive ideals (which is pretty obvious to me with even my half brain), but then the big question is so what? in extreme cases, governments might want to do something about it, where they can. Or as you say, the response, if designed on PC market models, might be flawed anyway.

[Fyfel Moon-Cusit]

A world without perfect competition would make it very difficult to give homework assignments to first year econ students. Those simultaneous equations just wouldn't make sense, otherwise.

Out of compassion for econ professors the world over I'm launching a "Keep Competition Perfect" campaign. You lot are sacrificing legant mathematical style for imagined real world phenomena. Pull yourselves together *slap*