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How Much Do Prices Respond to Demand and Supply Shocks?

Author

Listed:
  • Seong-Hoon Kim

    (Yonsei University -- Mirae)

  • Seongman Moon

    (Jeonbuk National University)

Abstract

This paper presents a theoretical examination of price responses to movements in demand and supply where firms face either unwanted inventories or stockouts in each period. The response mechanism consists of two complementary motives that arise when operating under uncertain business environments. To an increase in demand, a firm has a motive to lower its price reflecting lower effective marginal costs but also has another motive to raise its price to rebalance expected marginal revenues associated with two distinct demand states, unwanted inventories and stockouts. These two motives cancel out each other at optimum, resulting in a limited response of prices to demand shocks. To a cost-push shock, the firm has a motive to raise its price reflecting higher effective marginal costs for a given output level and is further prompted to raise prices reflecting a higher expected value of unit inventory. The two motives push prices up in the same direction, resulting in a large response of prices to supply shocks.

Suggested Citation

  • Seong-Hoon Kim & Seongman Moon, 2024. "How Much Do Prices Respond to Demand and Supply Shocks?," Korean Economic Review, Korean Economic Association, vol. 40, pages 289-314.
  • Handle: RePEc:kea:keappr:ker-20240701-40-2-03
    as

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    File URL: http://keapaper.kea.ne.kr/RePEc/kea/keappr/KER-20240701-40-2-03.pdf
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    References listed on IDEAS

    as
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    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Demand Shock; Supply Shock; Price Responsiveness; Effective Marginal Cost; Loss-balancing;
    All these keywords.

    JEL classification:

    • E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)
    • L11 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Production, Pricing, and Market Structure; Size Distribution of Firms

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