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40, No. 4 (Winter, 2009), pp. 673-687 Published by: Wiley on behalf of RAND Corporation Stable URL: http://www.jstor.org/stable/25593733 . Accessed: 21/10/2013 01:04

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RAND Journalof Economics Vol. 40, No. 4,Winter 2009 pp. 673-687

Rockets

Tappata*

Mariano

Prices rise like rockets butfall like feathers. This stylizedfact ofmany markets is confirmed by I develop a model with competitivefirms and rational studies. In this article, many empirical consumers the where asymmetric response to costs by firms emerges naturally. partially informed

In contrast to public opinion and past work, collusion is not necessary to explain such a result.

1.

Introduction

Output prices do not react symmetrically to changes in inputprices. According toPeltzman's markets, comprehensive studyof 165 producer goods and 77 consumer goods, "In two out of three as rise than This is also known outputprices pattern faster they fall" (Peltzman, 2000; p. 480). rockets and feathers and has sometimes been used interchangeablywith the term asymmetric pricing} Despite the abundance of empirical work confirming this stylized fact, there has not been much progress in terms of theoretical explanations for this widespread phenomenon.2 The first thing that comes tomind when talking about rockets and feathers is collusion. A classical example is gasoline retailing, a market operated by a handful of players with are usually associated with collusive behavior by both government and themedia.3 However, Peltzman finds that the rockets and feathers pattern is equally likely to be found in both concentrated and atomistic markets. In this article, I develop a consumer-search model that

* University of British Columbia; mariano.tappata@sauder.ubc.ca. I am grateful to the editor,Mark Armstrong, and two anonymous referees for suggestions thathave significantly improved the exposition of the article. This is a revised version of the first chapter of my dissertation. I would like to thankmy advisors Hugo Hopenhayn and David K. Levine forgreat advice and support. I am also indebted to Florencia Jaureguiberry, output and input prices easily observable by everyone. Asymmetric gas price adjustments

Christine Hauser, Dan Ackerberg, Roberto Alvarez, David Rahman, and participants at theMidwest Economic Theory Meetings (Fall 2005) and seminars at various universities for helpful suggestions and discussion. Financial support from theUniversity of California Energy Institute is greatly appreciated. 1 To the best ofmy knowledge, Bacon (1991) was the first to use the term rockets and feathers to describe the pattern of retail gasoline prices in theUK. This label suggests asymmetries in the immediate adjustment to a cost change as well as in the number of periods needed for a complete adjustment. The main focus of the literature?and this article?is on the former asymmetry. I return to this point in Section 3. 2 The majority of the empirical work is concentrated in the gasoline market (Bacon, 1991; Karrenbrock, 1991; Borenstein, Cameron and Gilbert, 1997; Lewis, 2005; Deltas, 2007; and Verlinda, 2008, among others). Other markets studied include banking (Hannan and Berger, 1991; Neumark and Sharpe 1992; and Arbatskaya and Baye, 2004), beef and pork (Boyd and Brorsen, 1998; and Goodwin and Holt, 1999) and fruits and vegetables (Ward, 1982). 3 See Karrenbrock (1991, p. 20) formedia and government representative quotations about gasoline price gouging.

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674

explains how an asymmetric response of prices to costs can arise in highly competitive

markets.

According to traditional economic theory,homogeneous firms that compete on prices earn zero profit, and cost shocks are completely transferred to final prices.4 The nature of this equilibrium changes drastically if consumers are imperfectly informed of market prices and a fraction of them has positive search costs. Firms now profit from ignorance in the market, and the equilibrium is characterized by price dispersion instead of a single price. Still, for any given level of production costs, firms' optimal price markup is the same regardless of whether their cost shock was positive or negative. In order to obtain asymmetric pricing, the demand function faced by the firmsmust be sensitive to previous cost realizations. This is indeed what happens

when consumers don't observe the firms' current

I introduce uncertainty over production costs in a nonsequential search model similar to Varian (1980) and Burdett and Judd (1983). Given consumers' search intensity, firmsmaximize are that less under than under low profit by choosing prices dispersed high production costs, since their scope to set prices?measured by the gap between marginal cost and themonopoly price?decreases. Rational consumers anticipate this and thereforethenumber of consumers that choose to search is lowerwhen costs are expected to be high. Intuitively, when input cost shocks are not independent over time, consumers' expectations differ depending on whether cost was high or low in theprevious period. This translates intodifferentdemand elasticities faced by firms when cost falls or rises and therefore,prices react asymmetrically to cost shocks as the firms' market. pass-through increases with the level of competition (search intensity) in the The rockets and featherspattern emerges under persistent cost realizations. Suppose that the currentmarginal cost is high. Consumers expect it will remain high, so they expect littleprice and search If in little. fact the very dispersion unexpected occurs and marginal cost drops, firms have little incentive to lower theirprices because consumers are not searching verymuch. On the other hand, if marginal cost is currently low, it is likely to stay low, so next period price dispersion is expected to be high, consumers' search intensifies,and the response by firms to a positive cost shock is to raise prices significantly. The contribution of this article is in formalizing a model with rational agents that isolates the crucial features needed for asymmetric pricing to emerge in noncooperative markets. Costly

consumer search stories have been suggested by some empirical studies as a possible explanation

production

cost.

for the rockets and featherspattern (Johnson, 2002; Borenstein, Cameron, and Gilbert, 1997; and Lewis, 2005). Lewis goes a step furtherand develops a reference-price search model whereby consumers form adaptive expectations about the current price distribution and firms use this myopic behavior to their advantage when settingprices. In this article consumers form rational model is related toDana's expectations and use all informationavailable to them. In that sense, the Previous work on asymmetric pricing focuses on differentfeatures of oligopolistic markets. On the one hand, Borenstein, Cameron, and Gilbert (1997) suggest a model of tacit collusion with imperfect monitoring, as inTirole (1988). With multiple equilibria, firms collude using the past-period price as a focal point. Decreases inproduction cost facilitate coordination on previous

(1994) study of the consequences of production cost uncertainty on consumer search strategies.

price, while ifcost increases it is likely that thepast price is unprofitable, collusion breaks down and a higher price emerges as a new equilibrium. On theother hand, Eckert (2002) uses amodel of Edgeworth cycles to explain retail gasoline price movements that are observationally equivalent to rockets and feathers although independent of cost shocks. This pattern has been observed in some Canadian cities (Noel, 2007) and is differentfrom the one this article tries to explain. model in this articlewere presented byYang and Ye (2008) More recently,alternatives to the and Cabral and Fishman (2008). While I assume symmetric learning by consumers, Yang and Ye

4 Although firmswith market power and costless consumer search don't transferall of their cost shocks to consumers, they still price symmetrically in that the price they optimally charge depends only on current cost realizations, not on previous costs. Therefore, the rate of change in prices is always the same (as a function of costs) regardless of previous prices, which eliminates the possibility of rockets and feathers.

?RAND

2009.

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TAPPATA

/ 675

(2008) focuses on rockets and feathers produced by asymmetric learning. In order to do this, the authors relax other assumptions thataffect the equilibrium outcome generating differentempirical model in this article.5 The price dispersion inYang and Ye (2008) consists implications from the of a two-point distribution that includes the monopoly price. Additionally, the time needed for a to cost shocks is asymmetric. In contrast, the price dispersion in of prices complete adjustment this article consists of a finite number of prices drawn from a distributionwith compact support. Also, the number of lags prices need to fully adjust to both positive and negative cost shocks is symmetric.That is, prices react initially faster to a positive cost shock than to a negative shock, but the remaining adjustment is done at a slower pace. model where firms have heterogeneous cost Cabral and Fishman (2008) build a different shocks and consumers search sequentially. Consumers' willingness to search is low (high) when they observe small (large) price variations. Thus, firms' incentives to pass cost shocks to final prices differdepending on the size of these shocks.When cost changes are small, sellers increase prices moderately without losing customers but do not reduce prices. The opposite asymmetry occurs when the cost change is large. Both the driving force of the asymmetric price adjustment and the empirical predictions differ from the ones presented here.

The rest of the article is organized as follows. In Section 2, I describe themodel and the with the equilibrium of the stage game. In Section 3 the dynamic setting is introduced together rockets and feathers result. Section 4 concludes and points theway for future research.

2.

In this section I lay out a static model in which firms compete choosing prices and consumers decide whether to search or not based on some prior over thefirms' production costs. The model is an extension of Varian's model of sales (Varian, 1980) inwhich I endogenize consumers'

search decisions and

environment that is introduced in thenext section. Consider a market with n firms selling a homogeneous good and with the same marginal and average cost. At the beginning of the period, Nature draws the cost for the industry, firms observe the cost realization and compete through prices. There is a continuum of consumers of measure 1 who know only the probability distribution of the production cost. They each have a unit demand with a choke price of v, and can obtain information about market prices prices in themarket and, therefore,buys from the cheapest store.Alternatively, an uninformed

consumer can only buy from a Nonsequential search protocols store selected randomly are especially appealing and faces no cost to consumers when of observing its price.7 there are economies through all-or-nothing nonsequential search. A consumer that chooses to search observes all the

section are the following. First, themarket equilibrium involves price dispersion and a fraction of informed consumers (Proposition 2). Second, the search intensity in the market decreases with the expected production cost (Lemma 2).6 This static model serves as the stage game in a dynamic

incorporate

uncertainty

over

production

costs.

The

two main

results

of this

of scale inprice sampling. Products thatare advertised in weekly newspapers are a classic example of such advantages. More recent examples include online shopping where specialized websites

aggregate ofa and compare search.8 all the relevant information across stores, saving consumers the trouble sequential

5 The main

differences between

distribution of consumers'

reside on the assumptions about the number of firms and the in Section 2 assumes a finite set of firms and consumers with

heterogeneous search costs, Yang and Ye assume a continuum of firms and restrict the critical consumers to have identical search cost. 6 As will be clear below, search intensity, the number of informed consumers, and the fraction of searchers are equivalent concepts. I use them interchangeably throughout the article. 7 All-or-nothing is a special case of nonsequential search. Burdett and Judd (1983) allow searchers to choose the number of prices sampled. 8 See Morgan and Manning 2009. (1985) for a discussion on the optimal search protocol.

?RAND

676

The cost of becoming informed is the search cost. Assume that a portion X e (0, 1) of the consumers has zero or negative search cost. I refer to them as shoppers. Shoppers can be interpretedas consumers who enjoy searching forprices orwho have obtained price information ? unintentionally through advertising or while shopping for other goods. The remaining (1 A.) consumers have positive search costs that are drawn from a continuous and differentiable = [0, s]. probability functiong(st), with st e S Given the nature of the search protocol, consumers and firms decide their actions simultaneously. The search/no search decision by consumers will be affected by the expected price dispersion in themarket and their search costs. Thus, based on their priors about the marginal cost realization, consumers form rational expectations on firms' pricing strategies to forecast the gains from search. At the same time, firms set theirprices anticipating the search market. intensity in the More formally,firms and consumers play a simultaneous-move Bayesian game with a set N = {NF U ND} of players, where j e NF = {1, 2,..., n] denotes a firm and i e ND = [0, 1] a consumer. Producers can be of either type cL or cH, where the probability of the high cost cH is a. The distribution of consumers' search costs (or their types) st e S is public knowledge. Firms choose prices pj in the intervalP = [cL, v] and consumers choose actions at e A = {0, 1} = = {don't search, search}.9 Letting /x fQ atdi represent the number of informed consumers, the a that ofa profit firmy charges price pj and has production cost c is given by:

Xj(J>j> P-jlc)

(Pj

c)

? where p_j represents the minimum price charged by firrn/'scompetitors, k e {1,...,? 1} is the number of competitors thatchose p_j9 and I is an indicator function. the conditional Meanwhile, utility ofa consumer iwith search cost s{ is: = vUiiatiSi) ai(rmn{pu ..., pn} + st) (1 a()- VV-. *-^

n y=i

?^j

+ vl{Pj<P_j} +

J*]p[lipj=p-j) j

0)

"

(2)

A strategy profile for the firms is represented by all possible price distributions given a = 1. > 0 for all p e P and cost realization: oF = {/}( , p)}JeNF with f(p;c) JPfj{p\c)dp on e A have that include the the other ; Consumers, hand, (A) possibility of strategies qt(- st) summarized by theproportion of informed consumers /x. Any strategyprofile for the consumers aD = {qi{'\Si)}ieND implies a value of/x e [X, l].10 Define a Nash Best Response NBR(fi, c) as a symmetricNash Equilibrium of the game played by thefirms given the search intensityand production cost. A Symmetric Bayesian Nash Equilibrium (SBNE) or market equilibrium is composed of consumers' consistent beliefs about themarginal cost (a) and a strategyprofile a = (aD, crF) such that /)oD is a best response to oF and ii) oF is aNBR(ia (crD), c). Inwords, a market equilibrium is characterized by consumers

randomizing between search and no search. The interaction between consumers and firms can be

that search optimally given the pricing strategies of the firms, and firms that set prices optimally given the number of consumers thatdecided to search. model by obtaining the firms'NBR. A given number Start analyzing the supply side of the of informed consumers /xcan be related to the expected elasticity of demand faced by each firm. = 1. The former = 0 and /x This is clear when we examine the extreme cases of /x corresponds to n separate monopolies. Each firm faces a completely inelastic demand and maximizes profits = v). On the other hand, when all consumers are by extracting all the consumer surplus (p = informed about themarket prices (/x 1), firms face perfectly elastic demands that leave them

91 ignore the consumer's decision between buying or not by setting v as the upper bound for pj .This simplifies notation and does not affect any result. 10 This is consistent with the definition of shoppers given above. If shoppers are thought of as consumers with zero search cost, I break any potential indifference in (2) by assuming they always search.

?RAND

2009.

TAPPATA

/ 677

< 1), each firm faces an no option but to price atmarginal cost. In the rest of the cases (0 < /x no to that It is there is demand. downward easy single price equilibrium verify sloping expected (SPE) since a store would capture the informed consumers /xby slightly undercutting its Denote the cumulative distribution implied by a particular equilibrium strategyprofile oF by c). By the same argument used to rule out SPE, allmixing strategies that involve a positive F(?, /x; mass over any price can be ignored.A firm is indifferent between charging themonopoly price v and any price above or equal to a lowerbound p* > c: High prices increase the markup per unit

in the market. The reverse occurs when low prices are chosen. These surplus-appropriation and competitor.11

sold but decrease the expected market share by reducing the likelihood of being the cheapest firm

business-stealing effects characterize the trade-offfaced by firms and, as Varian (1980) shows, induces price dispersion (sales) in equilibrium. Proposition 1. There is a unique Nash Best Response distribution ofmarket prices is F(p, forall/>e[/?* = = /x; c) 1--? aF. Given /x and c the cumulative

(3) fin(p c)

c+M^,u].

Proof. Varian (1980). The share of informedconsumers affects thepricing strategies of thefirms in twoways. First, as /xincreases, there is a smaller captivemarket for each firm and theprofit made by charging the as the of that the firms indifferent, This increases decreases. range prices keep monopoly price consumers. same are to in to attract At set order the informed the lower time, prices they willing a larger proportion of informed consumers makes the business-stealing effectmore attractive, more weight isplaced on low prices. This can be seen in (3) as F(?, /x')first-order hence relatively < /x. dominates F(-, /x)for /x' stochastically market increases the likelihood of observing Notice that the presence ofmore stores in the extremes in distribution. This is because the chances of being the lowest price in the of the prices the market decrease with n and middle-range prices will most likelynot be enough to capture the informed consumers. But the strengtheningof the business-stealing and surplus-appropriation effects is not symmetric.As n increases, the probability of being the lowest price in themarket decreases exponentially while thebenefits from charging high prices decrease at a rate \/n.Thus,

the surplus-appropriation effect becomes relatively more important than the business-stealing

effectand firmsprefer to increase the likelihood with which they set prices close to the monopoly price.12 Figure 1 shows the price distributions for differentvalues of n. On thedemand side, consumers decide between becoming informed about the market prices (at a cost st) or buying from a random store. The market demand is composed of consumers whose individual choices at do not influence the search intensity in themarket. Given thefirms' NBR, the expected benefit for each consumer of being informed ismeasured by the difference between the expected price and the expected minimum price in the market (price dispersion):

E[p-pmin\n] = E

= Alternatively, lettingz restated as 1 ? F(p9 ^

f p[\-n[\-F(p,ii9c)rX]dF(;ii-c).

(4)

1* Note that SPE and pure strategies equilibrium are the same since an NBR is defined to be a symmetric NE. 12 Even though in the limit the price distribution F converges weakly to the monopoly price (Stahl, 1989; and Janssen and Moraga-Gonzalez, 2004), its support widens with n and the lower bound approaches themarginal cost. ?RAND 2009.

678

FIGURE 1 = 0.2) EQUILIBRIUM PRICE DISTRIBUTION AND NUMBER OF FIRMS (c= 0, fi F(P) f(p)

^-

*^^

?v

^? 0 I

P*n=100 Pn=3 P P*n=10

?-^

n=2 v

E[p

pmm Ml I

where is [c] = acH + (1 ? a) cL. An individual is more likely to search if the expected price dispersion is large. At the same time, theprice dispersion depends on the number of informed consumers. Starting from a = = monopoly situationwith no price dispersion (/x 0 and p v), as /x increases and the profits fade away, thefirms startsampling prices from a wider support and placing relatively more weight on low prices. This has the effect thatboth the expected price and the expected minimum price decrease. But theydo so at differentrates and there exists a number of informed consumers /xat > /x, which the consumers' gains from search aremaximized. For /x adding informed consumers generates a positive externality on those thatremain uninformed because the spread between the average price and minimum expected price is reduced. The following lemma characterizes the benefits of becoming informed.

1. Consumers'

/ V Jo

-?f?-:- finz"-1+ 1

fi

(1

- nzn l)dz

(5)

Lemma

of informed consumers. Furthermore, the gains from search increase with thenumber of firms in the market: E[p Pmm \v,n]> E[p n pmm | /x, = 2] = (v - E [c]) log- ? 2/x2 |_ L 1 A6 J 2/x . (6)

expected

gains

from

search

is a strictly

concave

function

of the number

Proof.

See theAppendix.

A consumer decides to search if thebenefit of becoming informed is greater thanher search cost. Thus, shoppers always search for low prices, while consumers with search cost higher than

v ?

(1 X) (1 g(v p*)) are uninformed. For the remaining consumers, the optimal search = 0 where 7 is the search cost of the indifferent = 1 and < are q(st 7) q(s{ > J) strategies

consumer:

p*

never

search.

Hence,

in any market

equilibrium

at

least

X consumers

are

informed

and

E[p

= Pmm I\i X +

(1

X)g(7)]-7=

0. (7)

There is potentially more than one solution to (7) depending on the number of shoppers, the distribution of search costs and the parameters that affect the gains from search. Figure 2 illustrates the case inwhich search costs are uniformly distributed across nonshoppers. The proportion of informed consumers ismeasured on thehorizontal axis, while the search costs and gains from search are shown on the vertical axis. The dashed and solid concave curve depict

the gains ?RAND from search to consumers. Each consumer compares her search cost with the gains 2009.

s,E[p-pmin\\L]

/ 679

_Z-____-.?-L

0 A A+(1-A)g(s)

from search given the total number of informed consumers. The straight linewith positive slope represents the search cost of themarginal consumer that decides to search. There is a unique equilibrium represented by the intersectionof the two curves. Consumers with search cost lower than? search and thosewith higher cost choose to remain uninformed. The following proposition states the conditions required for a unique market equilibrium.

Proposition 2. There is a unique market equilibrium if: or a) A > /x, and b) 0 < X < /x ^ Proof. See theAppendix. > Mfc?__l over ^ e [x,?].

The market equilibrium is characterized by price dispersion and a proportion of informed consumers.13 The equilibrium search intensity is a measure of how strongly thefirms compete in prices and is influencedby the expected production cost through its effecton theprice dispersion. Even though the level of theproduction cost does not affect the trade-offsfaced by thefirms when relative benefits and costs of attracting the informed consumers are the same under low and high costs, but as production cost increases, the gap between themonopoly price and theminimum = profitable price/?* decreases (the extreme case being c u). This negative relationship between consumers cost to search less when they expect high and induces price dispersion production costs. As can be seen in the duopoly case (6), the gains from search E[p ? pmin | /x]become as theprobability of high cost increases. Thus, the indifferent flatter consumer has a lower search cost and the equilibrium search intensitydecreases with a. Lemma 2. The number of informed consumers decreases with the expected production cost. Proof. See theAppendix.

setting prices, it alters the range over which firms can choose those prices. In other words, the

The relevance of this comparative staticwill be more apparent in the next section, where I which consumers' priors are based on past cost realizations. Changes present a dynamic setup in in theirpriors imply changes in the search intensity which in turnaffects theway firms pass cost

13 An example of multiple equilibria can be obtained when there are few shoppers and all nonshoppers have the same search cost (degenerate g). Nevertheless, given thatX > 0, any of themarket equilibria implies price dispersion and At (0, 1) (Tappata, 2006). ?RAND 2009.

680

duopolies, the results of this section hold for the concave and convex demand functions of the ? form q(p) = (1 pf, with /3> 0 (Tappata, 2006). In all these cases, consumers search less when they expect higher production costs for two reasons: First, the gain from search per unit (price dispersion) decreases and second, the incentives to search are lower because consumers expect to buy fewer units.

shocks to finalprices. Before turning to that, it is important to note that the results in this section should not be restricted tounit demands. If consumers have multiunit demands, thefirms' pricing strategies take into account the search intensity as well as the price elasticity of consumers' demand, and thegains from search are a function of theprice dispersion and theprice level. The and it can be shown that, in the case of extension to the linear demand case is straightforward,

3.

Dynamics

and asymmetric

pricing

In this section, I present a simple dynamic model that sets out the conditions under which asymmetric pricing in highly competitive markets holds. The main result is captured by Proposition 3. Firms react differentlytopositive cost shocks than to negative shocks as long

as those shocks are not i.i.d. Given that consumers do not know the actual

The rockets and feathers and asymmetric pricing labels have been used by the empirical literature to describe the immediate reaction of output prices to input cost shocks. These studies find that the immediatepartial adjustments of output prices to a positive cost shock are larger than after a negative cost shock.14 Interestinglyenough, there is no clear evidence that the time taken for output prices to fully adjust to cost changes is asymmetric (See, e.g., Borenstein, Cameron, must be the case thatoutput prices initially and Gilbert, 1997; and Peltzman, 2000). Therefore, it react fasterwhen the input cost shock is positive but the reverse occurs as the total adjustment is

near

their search decisions are linked to past cost realizations and firms face demands with different elasticities, depending on whether the cost dropped or rose in thepast period. This demand change model, it implies asymmetric cost pass-through by thefirms.Before getting into the setup of the is important to characterize more precisely the rockets and feathers pattern.

production

cost,

The majority of the asymmetric pricing studies estimate a dynamic model of the following type:

completion.

&y>= E

m+

m~

/=o

# (A*<-')++H

/=o

where yt and xt represent output and inputprices, and A theirchange with respect to the levels in ? act as indicators for the previous period. Abusing of notation, the superscripts+ and positive and negative cost changes. The model in (8) allows for differenteffects of positive and negative m+ cost shocks on prices and itassumes thatoutput prices adjust completely to a cost shock after

orm"

responsefunctions CRF(k) can be constructed for each typeof shock. These functionspredict the cumulative price adjustment after k periods from a one-time cost shock and are used to test for asymmetric pricing.17The rockets and feathers evidence consists of theCRF+ being (statistically) as the periods away from larger thanCRF~ for low values of A:and theirdifference disappearing model below generates. the cost shock approach min{m+, ra-}.18 That is the pattern that the

14 See footnote 2 for references on empirical work. 15 The number of periods is also estimated and there is no clear evidence on whether m~ ^m+.\n many cases, data restrictions prevent the econometrician from including a sufficient number of lags and therefore only partial adjustments are studied (Peltzman, 2000). 16 The last term in (8) includes a white noise error term as well as an error-correction term that accounts for the

periods.1516

By

separating

the effects

of positive

and

negative

cost

changes,

a cumulative

current deviations from a long-run equilibrium relationship between the output and input prices. 17 See Borenstein, Cameron, and Gilbert (1997) for a description of the CRF construction from the estimated parameters in (8). 18 An example of this pattern for retail gasoline prices can be seen inBorenstein, Cameron, and Gilbert (1997). ?RAND 2009.

TAPPATA

/ 681

Consider a dynamic environment inwhich the static game presented in the previous section is repeated over time.Assume thatat thebeginning of each period,Nature chooses a high or low ? production costwith probabilities a and (1 a). After that,each firmobserves the cost realization and sets prices while consumers observe theprevious period cost realization and decide whether to search or not. The next period starts after themarket clears, and the process is repeated. I main motivation for this concentrate on the analysis of a Markov Perfect Equilibrium. Since the model is to explain asymmetric pricing in atomisticmarkets, I ignore thepossibility of collusion There are two sources of average-price variation over time in this setup. On the one hand, a expected prices can change as a reaction to a change in the production cost. All else equal, as a can of result On other cost the hand, vary prices implies higher prices. higher production a change in consumers' priors. This is an indirect effect on expected prices thatmaterializes Firms can anticipate this change and adjust their through thevariations in the search intensity /x. The expected market prices are completely characterized by the currentproduction cost level and the amount of search in themarket. For simplicity, let the probability of high costs follow a ? Markov process a = h(ct_x)where h(cH) = p and h(cL) = (1 first-order p) with 0 < p < 1. It then follows that there is a one-to-one map between the previous period cost and the actual search intensity. Therefore, the state of the economy can be represented by past and current cost realizations. Denote the current state by k = (c,_i, ct). Because production costs can only be low or high, there are four possible states denoted by the setK = {LL, LH, HL, HH} with kt= K(i). Given a current state kt, the probability ofmoving to a new state kj next period is denoted matrix: by the element Ptj in the following transition

prices accordingly.19 among firms.

Yp

p = 0

\-p

0

o

1- p

o"|

p

\ p _0

1- p 0

0 1-

0 p p I

= Thus, if the current state involves low actual and low past cost realizations (kx LL), itcan never = = PX4 0). Last, there is a happen that the next state indicates high as the previous cost (P13 ? K and that is represented by n = {p/2, (1 ? p)/2, (1 p)/2, unique invariantdistribution for In this simplifiedworld, it takes only two periods forprices to fully adjust to an isolated cost change.20 After a shock, firms increase (decrease) prices reacting to bigger (lower) production costs. In the following period, assuming production cost does not change, firms adjust prices to be consistent with the new updated prior held by consumers. After two periods, the prices are in line with the new cost level, and the size of the price adjustment is the same, independent of the sign of the cost shock. Therefore, asymmetric pricing, if any, has to be observed in the firstperiod of adjustment to a cost shock.We are interested in finding the conditions such that model would generate. Let pk be the average market First, consider the estimated fa that this a positive cost shock to occur, the previous cost the state the k. For is when of economy price realization has to be low. Thus, the previous statewas eitherLL orHL and the new state isLH. which the cost drops can only beHL while theprevious Similarly, for fa the state of theperiod in state could have been either HH or LH. The expected change inprices to a positive and negative cost shock are, respectively:

19 Note that firms set new?dispersed?prices in every period regardless of changes in the production cost or consumers' prior. The changes mentioned above refer to adjustments to the equilibrium distribution function fromwhich firms draw their prices. 20 Note that this is just a simplification. The length of the adjustment can be easily increased if the learning by consumers in the period following the cost shock was not perfect.

P/2}.

fa > fa in(S).

?RAND

2009.

682

E

E

Ac^ '

Ap'

=?v(LH)?v(HL\LH)[pLH-pHL]^?v(HH)?r(HL\HH)[pHH-pHL],

-^-

and using the transitionand unconditional probabilities (P and n), the difference becomes E

rAp 1

-^

~E

rAp i?i

^T

=^P(1-P)[(J>hh-Phl)-(Plh-Pll)]'

(9)

This last equation summarizes the conditions for asymmetric pricing. Note that the economy cannot move from a stateHL to a stateHH, so pHH ? pHL represents the change in expected an increase inproduction cost holding consumers' priors constant at a = p. Likewise, prices after

pLH ?

to anticipate that /J J^ fa if the cost shocks are not iid. The following proposition shows that the rockets and feathers arise ifp > 1/2.

pLL

represents

the increase

in prices

if consumers'

priors

are a =

. It is straightforward

Proposition 3. Output prices rise faster than they fallwhen inputprices show persistence:

Proof. See theAppendix. Intuitively,the rockets and feathers outcome is a consequence of firms facingmore inelastic demands when themarginal cost drops than when it goes up. Suppose thatmarginal cost is will remain high, so they expect littleprice dispersion and currentlyhigh; consumers expect it

pass most of it to prices. One way of identifyingthe drivers behind asymmetric pricing is by decomposing the terms and (iii) the effectof the search (ii) the effectof those priors on the equilibrium search intensity,

intensity on the cost pass-through. _ [(Phh ~ _ Phl) ~ _ (Plh That ~ _ Pll)] is, = Ap -t1 Ct-\=CH Ap -T in the square bracket of (9) into: (i) The effect of previous cost realization on consumers' priors,

very few choose to search. If, in fact,marginal cost drops, firms have few incentives to lower theirprices because consumers are not searching verymuch. On the other hand, if marginal cost is currently low, it is likely to stay low, so next period's price dispersion is expected to be high, the proportion of consumers searching increases, and the response to a positive cost shock is to

l Ct-l=CL

Ap _Ac,^H

Ap Act ^J

with

= and [iH and \jllare the equilibrium search intensitieswhen consumer priors -?fj2^-, ? = \xH about theprobability of a high cost are h(cH) = p andh(cL) = 1? p, respectively, (A /x /jll).

Hence,

d^^

In the previous section, Lemma 2 showed that a higher expected production cost implies a lower search intensity. Lower gains from search are associated with higher costs since, as thegap between themarginal cost and themonopoly price is reduced, price dispersion decreases. Thus, < 0). Now want to become informeddecreases with the equilibrium pool of consumers that a(|^ turn to the effect of search on the cost pass-through. The limiting cases of perfect competition and monopoly are useful benchmarks. In a perfectly competitive environment, prices are driven

?RAND 2009.

/ 683

n=2X

^^

n=10^^^

^=

~~

===^TrjQ

,

1

entirelyby costs and a complete pass-through is expected after a cost shock. On the other hand, the monopoly price is not affected by cost shocks. An monopolist pass-through is zero since the increase in the number of informed consumers is similar to an increase in the elasticity of the expected demand faced by each firm. In otherwords, as more consumers become informed, the market gets more competitive and the link between costs and prices is stronger.Firms compete more fiercely for the increasingmass of informed consumers by settingprices closer to marginal > 0). cost. As a result, the cost pass-through increases with [i{^Figure 3 shows the cost pass-through and search intensityrelationship for differentnumber of firms.Note that the convergence to the complete pass-through happens at a lower pace in = markets with more sellers. Starting from /x 0, as consumers become informed, the surplus more in markets. That is, for a given /x> 0, firms in atomistic effect is stronger appropriation markets with more sellers sample high prices more often than low prices and average prices are further away from the marginal cost. Therefore, holding thenumber of informedconsumers fixed,

each firm is more concentrated on its captive consumers and?like a monopolist?has fewer

incentives to adjust prices to cost shocks. Finally, the sign of (9) is determined by the process behind a. thefirms ina givenmarket.While this is consistentwith the empirical testsof rockets and feathers, one might argue that the relevant question iswhether we observe this asymmetric pattern in the prices paid by consumers. To answer thisquestion, the expected prices in (9) need to incorporate

It is important to note that the result obtained above is related to the average price chosen by

the fact that the firmwith the lowest price in themarket has a high market share and than the remaining firms sell only to uninformed consumers. Denote this expected price by p = It can be shown that

E ?

fiE[pmin |c] +

(1

p)E[p

|c].

fAp 1 -E

fA/? 1 =

? 1

p{\ -p)(cH-cL)(iiH-iiL).

This expression is positive when there is cost persistence because consumers assign low probability to a change in theproduction cost and (by Lemma 2)ixH < \iL . The intuitionfromProposition 3might be helpful when thinkingabout asymmetric pricing in other environments. Although a complete analysis is outside the scope of this article, some insights can be obtained for the case where consumers search sequentially. Under this protocol, consumers' optimal search strategy comprises searching for an additional price only when the

lowest ?RAND observed 2009. price is above some reservation value. The analysis with an unknown and

684

endogenous price distribution ismore involved than in the case of nonsequential search and the usual simplifying assumption adopted in the literature is thatnonshoppers have a common search cost (Rothschild, 1974; Reinganum, 1979; Stahl, 1989; and Benabou and Gertner, 1993). As a only consumers thatengage in active search. Firms draw prices from a distribution as in (3) where v is replaced by nonshoppers' reservation value (Stahl, 1989). The analysis does not change considerably when

reservation value is based on the Consumers' previous cost realization. The current cost consequence, firms never choose a price above the unique reservation value and shoppers are the

information is updated from the observed prices, but consumers still find it suboptimal to search for a new price quote (Dana, 1994; and Tappata, 2006). Let vH and vL denote the reservation values for nonshoppers associated with a high and low past cost realization. It can be shown that the expected price in themarket is a linear combination of the production cost and the ? ? = reservation value (equation (Al) in the pLH pLL in (9) and Appendix). Therefore, pHH pHL react to cost we the shocks. From know that the rockets prices symetrically previous analysis, and feathers pattern occurs as a consequence of the search intensitychanging with consumers' priors. Thus, thenonsequential model suggests thata necessary condition for asymmetric pricing in sequential search environmentswould be to relax the assumption of homogeneous search costs The main point of thisarticle is thatconsumer search can play an importantrole in explaining the rockets and feathers. In general, decentralized markets share the feature thatconsumers do not know all theprices quoted by the firms. This is the case of gasoline retailing, probably the most well known case of asymmetric pricing.21 Furthermore, the additional modeling assumptions fit well with the characteristics of the industry. Gas stations in a same geographic market sell a fairly homogeneous good and, since the technology does not allow for input substitution, the retail price 23 ismainly driven by thewholesale price of gasoline.22 Also, capacity constraints appear to be irrelevant at the retail level (Borenstein, Cameron, and Gilbert, 1997; and Noel, 2007). On the demand side, consumers are generally aware of the latest changes in the oil price (a good proxy movements in the for the wholesale price) and can use this information toupdate theirgains from search. Evidence that the price dispersion in the gasoline market is consistent with a model of nonsequential consumer search is found by Chandra and Tappata (2008). In addition, they show measures of price dispersion decrease with the price level of gasoline. Although that different search intensity is not observed, thisprovides indirect evidence that consumers search lesswhen they expect higher production costs, as predicted inLemma 2.24

for nonshoppers.

4.

Conclusion

The contributionof thisarticle lies indeveloping a theoretical explanation for theunexplained butwidely observed rockets and featherspattern. The model links thefirms' asymmetric response to cost shocks to the fact that consumers are imperfectly informed about market prices and the industry'sproduction cost. Consumers' search decisions affect thefirms' elasticity of thedemand and therefore their cost pass-through. If production cost shows serial correlation, the number of informed consumers in themarket depends on the previous cost realization and as a result the when the cost drops thanwhen it raises. cost pass-through exercised by thefirms is different

21 See footnote 2 and Geweke (2004) formore references on rockets and feathers in the retail gasoline market. 22 Gas prices can differ significantly between markets due to differences in local and state taxes, fuel requirements and supply conditions in the local upstream market. 23 The wholesale cost paid by each gas station could differ according to the degree of vertical integration between refineries and stations. However, evidence shows that the vertical contracts are motivated by agency conflicts (Shepard, 1993) and do not affect the stations' pricing strategies (Hastings, 2004). 24 Another industry that is heavily represented in the rockets and feathers literature is the banking sector. In this case, the evidence indicates that consumer deposit interest rates react slower to positive shocks to the open market interest rate than to negative shocks (Hannan and Berger, 1991; and Neumark and Sharpe, 1992). The consumer deposits market shares the same characteristics as the gasoline 2009. retailing market captured by themodel in Section 2.

?RAND

TAPPATA

/ 685

worth exploring in futureresearch. Inmany markets, sequential rather thannonsequential search is the optimal protocol for consumers, and even though the analysis of sequential search from unknown (and endogenous) distributions is notably more complicated, the insights from the nonsequential search model can be useful. Also, consumers in real markets do not get to learn uniformly the cost realization on the previous period. This simplifying assumption could be replaced by one inwhich the learning process is not homogeneous or perfect. It ismore likely that consumers who decided to search in the past are better informed than those who did not. That way, the search intensityadjustment to a cost shock would takemore than just one period and the adjustment of output prices to input cost shocks would be smoother. Contrary to public opinion and previous work suggesting collusive behavior as the cause of asymmetric pricing, this article shows that itcan well be the outcome innoncooperative markets. This finding reinforces the importance of consumer searchmodels in explaining actual markets'

The simplicity of themodel helps to identify themain forces that might drive asymmetric a comes at to the in markets. This and extensions model would price, pricing highly competitive to the its observed The search price patterns. protocol, the clearly improve capacity predict consumers' learning process, as well as the production cost stochastic process, are dimensions

The extent towhich price dispersion is explained by consumer searchmodels also functioning.25 has significantpolicy implications. Dispersed prices have differenteffects on welfare when there when consumer search is costly.Under product differentiation, less isproduct differentiation than lower market is associated with lowerwelfare. In contrast, (hence variety price dispersion) in the if consumer search is costly, policies oriented to eliminate search costs and price dispersion can be welfare improving.

Appendix

Proof of Lemma 1. Concavity --and d2E[p-Pmin\n] -?=-(v-E rri^ [l2nz?-\\-nz?-')2 [c]) /----r 3/x2Jo {ixnzn-x + 1 J dz < 0. /x) (4). To show that can be shown directly from (5): 9E[p /__ n] | = -(u rr ^ fl nzn'\\ dz E[c]) /-??3^ Jo {[inzn~x + J wz"-') 1- /x)2

E[p

The

gains

n =

= Pmin \n]

using (3) and integrating by parts cost to 0 and adjust v to v' in (5): ? \ 1_ n\ n

v'-r-dz. /

JO 1 + ^*-! (1 -11)

1- nzn~'

1+ ^

(n +

l)z"

and An = -

Jo I

An+l An

+ l)z" dz

] j

An+xAn

V'

(l-At)Uo

+ l)z-n]z-> [(n

An+xAn Z\ f-7-pn / > -

Jn/(n+i)

z""1 [n-(n

= \)z] dz

0.

Q.E.D. 25 An immediate application of these type ofmodels is in macroeconomics where recent findings show thatproduct differentiation alone does not do a good job in explaining the observed price rigidities and high frequency of changes on intra-industry relative prices (Klenow andWillis, 2006). ?RAND 2009.

686

2. Reexpress (7) using (4)

Proof ofProposition

Ey\[\

n[l

F(p, ^;c)rl]dF{,

^;c)]=

g~l

? = X+ = 0 while the LHS > 0. The At /x (1 X) g(0), theRHS gains from search (LHS) is a strictly concave function of /xand equals 0 at /x= 1. Thus, g~l cuts from below the expected gains from search at least once. If X > /x, it is easy to see that there is a unique solution to (7). If X < /x, the possibility of multiple solutions is eliminated under the Q.E.D. assumption thatg~l has steeper slope than the gains from search for any value of/x in the range (X, /x). Proof of Lemma 2. Let the equation in (7) be represented by G:

(^^Y

G=

where p, = X+ (1 X)g(7). By the IFT,

E[p-Pmm\jl]-g->(^^

dG_

OH

da The denominator is

9^

9G_' d7

\

because

87 9/x

9/x) 87

is negative). The numerator is

at 7, g~x cuts the expected price differential from below (the term in parenthesis negative as long as the gains from search decrease with a. Using (4), . pmin Ifi] dE[p finz"-1 n_ -= ( nzn l)dz (cH cL) [x /-???-(1 da \x J0 finz"-1 + 1 11-

+ \xnzn~x

/x

JY

finz"-] +

/x J

[z / (1 /x Jo

nz"

. l)dz

0.

Q.E.D.

3. The expected market price for a given cost realization c and search intensity /x is given by x trr i i ll) + C/xnzn-1 jev [V = [l V(\ -??-dz p E[p\c]= (Al) / pdF(p,fi;c)= / + 1 /X /XHZ""1 V^0 where the last equation is obtained by changing variables with z = 1 ? F(-). Let Q(/x) = dz. For a given previous period cost realization i, the difference in the expected prices f0 nz"-"+x_ associated with high and low current cost is Proof of Proposition PiH where ~ PiL =(CH ~CL)Q (/X()

\xL(Lemma

1). Q.E.D.

References

Arbatskaya, M. and Baye, M.R. "Are Prices 'Sticky' Online? Market Structure Effects and Asymmetric Responses to Cost Shocks inOnline Mortgage Markets." International Journal of Industrial Organization, Vol. 22 (2004), pp. 1443-1462. R.W. "Rockets and Feathers: The Asymmetric Speed of Adjustment of UK Retail Gasoline Prices to Cost Changes." Energy Economics, Vol. 13 (1991), pp. 211-218. Increased Inflationary Uncertainty Lead to Benabou, R. and Gertner, R. "Search with Learning from Prices: Does Higher Markups?" Review of Economic Studies, Vol. 60 (1993), pp. 69-93. Bacon, ?RAND 2009.

TAPPATA

BoRENSTErN, S., Cameron,

/ 687

to Crude Oil Price A.C., and Gilbert, R. "Do Gasoline Prices Respond Asymmetrically Changes?" Quarterly Journal ofEconomics, Vol. 112 (1997), pp. 305-339. Boyd, M.S. and Brorsen, B.W. "Price Asymmetry in the U.S. Pork Marketing Channel." North Central Journal of Agricultural Economics, Vol. 10 (1988), pp. 103-110. K. and Judd, K.L. "Equilibrium Price Dispersion." Econometrica, Vol. 51 (1983), pp. 955-970. L. and Fishman, A. "Business as Usual: A Consumer Search Theory of Sticky Prices and Asymmetric Price Adjustment." Department of Economics, Stem School of Business, New York University, 2008. Chandra, A. and Tappata, M. "Consumer Search and Dynamic Price Dispersion: An Application toGasoline Markets." Burdett, Cabral, Sauder School of Business, University of British Columbia, 2008. J.D. "Learning in an Equilibrium Search Model." International Economic "Assymetries in Retail Gasoline Price Dynamics 2007. University of Illinois, Urbana-Champaign, G. Review, Vol. 35 (1994), pp. 745-771. and Local Market Power." Department of Economics,

Dana, Deltas,

Eckert, A. "Retail Price Cycles and Response Asymmetry." Canadian Journal ofEconomics, Vol. 35 (2002), pp. 52-77. J.F. "Issues in theRockets and Feathers Gasoline Price Literature." Report to Federal Trade Commission, 2004. Goodwin, B. and Holt, M.T. "Price Transmission and Asymmetric Adjustment in the U.S. Beef Sector." American Geweke, Hannan, Journal of Agricultural Economics, Vol. 81 (1999), pp. 630-637. T.H. and Berger, A.N. "The Rigidity of Prices: Evidence from the Banking Review, Vol. 84 (1991), pp. 938-945. Industry." American Economic

Hastings,

J. "Vertical Relationships and Competition in Retail Gasoline Markets: Empirical Evidence from Contract Changes in Southern California." American Economic Review, Vol. 94 (2004), pp. 317-328. J.L. "Strategic Pricing, Consumer Search and theNumber of Firms." The Janssen, M.C.W. and Moraga-Gonzalez, Review of Economic Studies, Vol. 71 (2004), pp. 1089-1118. Johnson, R.N. "Search pp. 33-50. Costs, Lags and Prices at the Pump." Review of Industrial Organization, Vol. 20 (2002),

J.D. "The Behavior of Retail Gasoline Prices: Symmetric or Not?" Federal Reserve Bank of St. Louis Review, Vol. 73(4), July/August (1991), pp. 19-29. J."Real Rigidities and Nominal Price Changes." Working Paper No. RWP06-03, Federal Reserve Klenow, RJ. and Willis Board of Kansas City, 2006. Karrenbrock, "Asymmetric Price Adjustment and Consumer Search: An Examination of the Retail Gasoline Market." Department of Economics, The Ohio State University, 2005. P. and Manning, R. "Optimal Search." Econometrica, Vol. 53 (1985), pp. 923-944. Morgan, Neumark, D. and Sharpe, S.A. "Market Structure and the Nature of Price Rigidity: Evidence from theMarket for Consumer Deposits." Quarterly Journal ofEconomics, Vol. 107 (1992), pp. 657-680. Noel, M. "Edgeworth Price Cycles: Evidence form theToronto Retail Gasoline Market." Journal ojIndustrial Economics, Vol. 55 (2007), pp. 69-92. Peltzman, S. "Prices Rise Faster Than They Fall." Journal of Political Economy, Vol. 108 (2000), pp. 466-502. J.F. "A Simple Model of Equilibrium Price Dispersion." Journal of Political Economy, Vol. 87 (1979), Reinganum, pp. 851-858. M. "Searching for the Lowest Price When the Distribution of Prices Is Unknown." Journal Economy, Vol. 82 (1974), pp. 689-711. Shepard, A. "Contractual Form, Retail Price, and Asset Characteristics of Political Lewis, M.

Rothschild,

Varian,

Ward,

R.W. "Asymmetry inRetail, Wholesale and Shipping Point Pricing for Fresh Vegetables." Economics Association, Vol. 14 (1982), pp. 205-212. Yang, H. and Ye, L. "Search with Learning: Understanding Asymmetric Price Adjustments." Economics, Vol. 39 (2008), pp. 547-564.

J.The Theory of Industrial Organization. Cambridge, Mass.: MIT Press, 1988. "A Model of Sales." American Economic Review, Vol. 70 (1980), pp. 651-659. J. "Do Rockets Rise Faster and Feathers Fall Slower in an Atmosphere of Local Market Power? Evidence Verlinda, theRetail Gasoline Market." Journal of Industrial Economics, Vol. 56 (2008), pp. 581-612. Tirole, H.R.

inGasoline Retailing." The RAND Journal of Economics, Vol. 24 (1993), pp. 58-77. Stahl, D.O. "Oligopolistic Pricing with Sequential Consumer Search." American Economic Review, Vol. 79 (1989), pp. 700-712. Tappata, M. "Consumer Search, Price Dispersion, and Asymmetric Pricing." Ph.D. dissertation, UCLA, 2006.

from

?RAND

2009.

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