Optimal price adjustment: tests of a price equation in U.S. manufacturing

The following description and analysis of a firm in atomistic competition is motivated by the need to specify a dynamic equation of price behavior to be tested on U.S. manufacturing time-series data. It is shown that uncertainty of price information in a market composed of many competing firms leads to a model which is in the Evans tradition of dynamic monopoly theory. The key dynamic element is the firm's reaction to customer behavior in an uncertain price situation. Price uncertainty forces newcomers to the market to search for an acceptable price which is less than the marginal utility of the good. Old customers may decide to engage in search after a price increase, if the expected difference in search costs and price is less than the recently experienced price change. The implications of the theory are examined using phase diagram analysis and estimation. Of particular interest for empirical study are the effects of changes in model parameters on the time path of the optimal price. In line with the conclusions of the theoretical model, the estimates suggest that price adjusts to a moving equilibrium path in a variable manner determined by cyclical factors in the economy.