Quantity adjustment

Abstract: This paper presents a theory of rigidity, or more properly inertia, in the responses of economic variables to changing environments. The theory rests on three fundamental assumptions: (1) that firms are risk averse, (2) that firms are uncertain of the impacts of changing decision variables and (3) that this uncertainty increases with the size of deviations in decision variables from appropriately defined past level. Under these circumstances an optimal portfolio of incremental decision variable adjustments exists which (a) takes variance minimizing adoptions to environmental change as a point of departure and then (b) is weighted in favor of changes in variables whose effects are less uncertain. In considering price and quantity adjustments, this implies that price and wage adjustments should largely incorporate expected inflation and, from that point, should be small relative to quantity adjustments, since in most situations the uncertainties associated with the consequences of quantity adjustment should be smaller than those associated with price adjustments.

Abstract: This paper presents a theory of rigidity, or more properly inertia, in the responses of economic variables to changing environments. The theory rests on three fundamental assumptions: (1) that firms are risk averse, (2) that firms are uncertain of the impacts of changing decision variables and (3) that this uncertainty increases with the size of deviations in decision variables from appropriately defined past level. Under these circumstances an optimal portfolio of incremental decision variable adjustments exists which (a) takes variance minimizing adoptions to environmental change as a point of departure and then (b) is weighted in favor of changes in variables whose effects are less uncertain. In considering price and quantity adjustments, this implies that price and wage adjustments should largely incorporate expected inflation and, from that point, should be small relative to quantity adjustments, since in most situations the uncertainties associated with the consequences of quantity adjustment should be smaller than those associated with price adjustments.

Abstract: Evidence is presented on the long and short run relationship between the money market interest rate and loan and deposit interest rates charged by individual Spanish banks between 1988 and 2003 The results indicate that such relationships have been determined by a mixture of adjustment costs and market power of banks, which creates interest rate rigidity and asymmetries in the speed at which increases and decreases in the money market interest rate are translated into banking interest rates We also find that the price adjustment speed first decreases and later increases with market concentration, which is consistent with predictions from models that assume quantity adjustment costs

Abstract: I. INTRODUCTION There is convincing evidence that fixed costs of price adjustment may be large. Levy et al. (1997) found such costs to be 0.7% of a firm's revenue, and Zbaracki et al. (2004) found them to be 1.22%. In the presence of fixed costs of price adjustment, a monopolistic firm does not adjust its nominal price continuously, with the result that the real price and output generally deviate from their static monopoly level. At low inflation rates, the average output is higher than the static monopoly output if there is positive discounting (Danziger 1988) and depends on higher order derivatives of the profit and demand functions if there is no discounting (Benabou and Konieczny 1994). (1) Most of the literature assumes that only price adjustments are costly, while output can be continuously adjusted without cost. However, Bresnahan and Ramey (1994) document that there may be large fixed costs of quantity adjustments. Relatedly, many publications show that adjusting labor and capital inputs involves significant fixed costs. (2) Such costs may derive from loss of organizational capital (Baily et al. 2001; Jovanovic and Rousseau 2001), as well as from job protection rules, severance pay, and legal and administrative complications. In a framework with both price--and quantity-adjustment costs, Andersen (1995) and Andersen and Toulemonde (2004) demonstrate that only intermediate-size shock--but not large or small shocks--may affect output. For a constant inflation rate, Danziger (2001) shows that a firm's permanent production decreases with inflation at low inflation rates if discounting is positive, and Danziger and Kreiner (2002) that output capacity decreases with inflation if the elasticity of demand is constant and there is no discounting (see also Danziger 2003). The purpose of this article is to provide a simple general characterization of the output effects of a constant inflation rate if both price and quantity adjustments involve fixed costs. It is assumed that quantity adjustments are at least as costly as price adjustments, which implies that a firm's production is held constant at a permanent level. (3) Each firm then keeps its nominal price unchanged in periods of equal length, and the nominal price is adjusted so that the initial real price is the same in each period. Thus, a firm's optimal strategy consists of the initial real price, the duration of the periods with unchanged nominal price, and the permanent level of production. The article shows that in the absence of discounting, the effect of inflation on the aggregate production depends on how fast firms' marginal real revenue decreases with demand and that this effect is fully determined by the elasticity of the marginal real revenue with respect to demand. Thus, aggregate production decreases with inflation if the elasticity of the marginal real revenue always exceeds minus unity, increases with inflation if the elasticity of the marginal real revenue is always less than minus unity, and is invariant to inflation if the elasticity of the marginal real revenue always equals minus unity. Several studies have found that the comovement between output and prices is typically negative in the long run (Cooley and Ohanian 1991; Den Haan 2000; Den Haan and Sumner 2004; Fiorito and Kollintzas 1994). Within the framework of the present model, the negative comovement indicates that the empirically relevant situation is when the elasticity of the marginal real revenue always exceeds minus unity. This will be the case, among others, if demand functions exhibit a constant price elasticity less than minus unity (as assumed in Danziger and Kreiner 2002). II. THE MODEL Consider an economy with a unit continuum of identical consumers and a unit continuum of monopolistic firms producing differentiated perishable products. Each firm and its product are indexed by i, which is uniformly distributed on (0, 1]. …