GMAT Practice Test 5

Why Prices Stay Put

¹Economic theory long predicted that firms would adjust their prices promptly whenever costs or demand changed, since a price that lags behind market conditions sacrifices profit. Yet surveys of businesses consistently find that many firms change the prices of their products only once or twice a year, even when their input costs fluctuate monthly. The standard explanation for this rigidity is the "menu cost" hypothesis: changing a price entails expenses, such as reprinting catalogs, relabeling shelves and updating price lists, and when these expenses exceed the profit a firm would gain by adjusting, the firm rationally leaves its price alone.

²The menu-cost account has an appealing simplicity, but it has become harder to sustain. Online retailers, for whom repricing an item requires little more than changing a number in a database, might be expected to adjust prices almost continuously. Many do change some prices frequently, yet studies of online sellers have found that a large share of their prices remain unchanged for months at a time, much as in traditional stores. If the physical costs of repricing were the main source of rigidity, their near disappearance online should have produced far more flexible prices than have actually been observed.

³An alternative explanation locates the cost of repricing not in a firm's operations but in its relationship with customers. According to this view, buyers judge a price increase as fair when it reflects a visible rise in the seller's costs and as exploitative when it appears to reflect only increased demand. A firm that raises its prices whenever demand rises risks antagonizing customers, who may retaliate by shifting their purchases to competitors long after the price has returned to normal. Firms therefore hold prices steady through temporary swings in demand, accepting some loss of short-term profit in order to preserve goodwill.

⁴The customer-relations explanation also accounts for a pattern that the menu-cost hypothesis leaves unexplained: firms are notably more willing to raise prices after widely publicized cost increases, such as a jump in fuel prices, than after equally large increases that customers cannot observe. Menu costs are the same whatever the reason a price changes; what differs is the customer's perception of that reason. A theory of price rigidity, then, must look beyond the mechanics of changing a price to the meaning that customers assign to the change.