Price rigidity, market competition, and product differentiation

Abstract

This study develops a two-period model in which the manufacturer determines a price floor and sets production output before demand becomes certain. The model defines the distance between price floor and high-demand-state price in concern to the degree of price flexibility. While conflicting empirical results underscore the importance of theoretical underpinnings, this study shows that economies of scale determine the relation between market competition and price rigidity. A decline in output leads to higher average costs in the industry characterised by economies of scale, a hike in average costs adds pressure on the inventory liquidation that drives price cutting in the low-demand state. Prices tend to more fluctuate as the product becomes more homogeneous or more players enter into the industry. The knowledge of the relationship between market competition, product homogeneity, and price rigidity is critical in formulating antitrust and monetary policies.