Your critique on this statement: Profit maximization is one of the most fundamen

Question

Your critique on this statement: Profit maximization is one of the most fundamental assumptions in economics, yet is rarely directly testable because of data limitations and the complexity of most firms. This paper provides a case study of the decision making of a firm whose activities and administrative data records lend itself quite naturally to an analysis of the choices it makes regarding the choice of prices and quantities to deliver conditional on these prices. In addition, the primary decision maker in the firm is an MIT trained economist. An analysis of the data suggests that the firm does an exceptionally good job of making the daily decision regarding the quantities to deliver to customers. In stark contrast, the evidence suggests that the firm has charged prices well below the optimal level for more than a decade, even to the point of pricing on the inelastic portion of the demand curve. I conservatively estimate that the firm sacrificed 30 percent of its potential profit through mispricing. Although the findings of this paper apply directly only to the firm in question, there are reasons to believe that the results obtained here may be more broadly generalizable. It is not by chance that the firm does well in choosing what quantity to deliver. The problem is an intrinsically easy one in the sense that there is a direct mechanism linking the firms actions to the observed outcomes. By observing daily feedback about sales relative to product delivered, the firm is able to draw on an enormous volume of data in making the quantity decision. Any mistakes on the quantity dimension are quickly revealed and corrected. For firms more generally, the aspects of production which share these characteristics (such as inventory management and quality control) are well-studied, with substantial resources devoted by firms to optimizing these choices (e.g. Evans and Lindsay 1998, Silver et al. 1998). In contrast, the firm rarely changes prices – only four times in the entire 13 year period – and thus gets little feedback regarding the right price. Without feedback, the firm has no direct mechanism for learning whether it is pricing correctly. This pattern of real-time adjustments in production rates coupled with much less frequent changes in prices appears to be a common practice among firms (Cecchetti 1986, Kashyap 1995, Bils and Klenow 2004,). Even with feedback, to the extent that price changes are an endogenous response to shifting demand conditions, the data generated will not directly inform optimal pricing decisions. Rather, what is needed to identify the optimal price is exogenous shifts in costs, or arbitrary changes in prices (e.g. as generated by a randomized field experiment). The findings of this paper suggest that the absence of feedback (along with the inherent difficulty of the problem) makes it possible to sustain long run deviations from optimal pricing by an otherwise sophisticated decision maker.

Explanation / Answer

A key normative question in monetary economics concerns the optimal design of monetary policy in the presence of nominal price rigidity. An extensive literature has studied this question under the assumption that the timing of price changes is given exogenously, as in the Calvo (1983) model with Poisson arrival of price adjustment opportunities.1 Undoubtedly a useful Örst step, this literature is nonetheless subject to the Lucas (1976) critique in the sense that the timing of price changes in principle should not be treated as independent of policy.

This paper proposes a theory of supply shocks, or shifts in the short-run curve, based on relative-price changes and frictions in nominal price adjustment. When price adjustment is costly, firms adjust to large shocks but not to small shocks, and so large shocks have disproportionate effects on the price level. Therefore, aggregate inflation depends on the distribution of relative-price changes: inflation rises when the distribution is skewed to the right, and falls when the distribution is skewed to the left. We show that this theoretical result explains a large fraction of movements in postwar U.S. inflation. Moreover, our model suggests measures of supply shocks that perform better than traditional measures, such as the relative prices of food and energy.

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