Pricing When Customers Care about Fairness but Misinfer Markups
Erik Eyster, Kristof Madarasz, Pascal Michaillat
In various contexts, prices seem somewhat rigid: they are not fixed, but they do not respond fully to marginal-cost shocks either. Price rigidity has many implications in public economics, international economics, industrial organization, and macroeconomics. However, the theories developed to explain it find little support in surveys of price-setters, which indicate that firms stabilize prices out of fairness for their customers. This paper proposes a theory of price rigidity consistent with the survey evidence. The theory relies on two psychological assumptions. First, customers care about the fairness of prices: they enjoy more a good priced at a low markup than at a high markup over marginal costs. Second, customers misinfer marginal costs from prices: when prices rise after an increase in marginal costs, customers underappreciate the increase in marginal costs and partially misattribute higher prices to higher markups. As they perceive transactions as less fair, the price elasticity of their demand for goods rises, and firms respond by reducing markups. Hence, the passthrough of marginal costs into prices is less than one---prices are somewhat rigid. In general equilibrium, our theory explains why money is nonneutral and why the Phillips curve has a backward-looking component.