Macroeconomic implications of product variety.

Abstract

In the New Keynesian literature on macroeconomic fluctuations, researchers show that profit maximizing firms might not adjust their nominal prices in response to changes in market demand, if the cost of price adjustment appears to be higher than what they incur by leaving their prices unchanged (nominal price rigidities). Also, they show that, under certain conditions, the elasticity of adjusting their relative prices with respect to changes in aggregate output might be small (real price rigidities), which makes nominal price rigidity more plausible. Overall, relatively small costs in price adjustments might cause some inflexibility in nominal prices, which helps in understanding money non-neutrality. The present study contributes to the New Keynesian literature on real price rigidity. Specifically, I study the way companies adjust the number of their product varieties in the market, during the course of the business cycle, and how this influences their pricing policies, and specifically their "desired" price markups. In fact, I show that desired price markups may be countercyclical, due to the fact that market competition is procyclical. Countercyclical desired price markups imply that companies absorb a significant part of the procyclical changes in the marginal cost, through lower price markups, during economic booms, and higher price markups, during economic recessions. Consequently, their sensitivity of not adjusting their relative prices in synchrony with the business cycle is lower than if desired price markups were constant. In the second chapter of the thesis, I formalize the above idea by using Hotelling's model of spatial allocation. In the third chapter, I generalize the same mechanism in the context of both Hotelling's spatial allocation model and the Chamberlinian model of monopolistic competition, by using different technologies. Finally, in chapter four, I test the mechanism I suggest, by using data from a specific market: the market for books in Ann Arbor.