Defending the Bank’s attack on “prices”
Posted December 11, 2008on:
Yesterday I said that I thought the Bank’s speech on bringing down the price level was ridiculous. Not only is asking for a decline in prices a strange thing for a central bank to do, the mentioning of “oil companies” was slightly off the mark – given that they have slashed prices in the face of falling crude oil (although to be fair the Bank was just asking them to keep going – it was the Dom Post that exaggerated it – or maybe I was being generous!).
Now I am going to defend it.
Say that we have a situation where firms in the economy are all oligopolies, and all set prices as their “‘choice”. When demand was rising these firms increased prices, and furthermore managed to implicitly collude to some degree (tacit collusion).
Now, when demand falls, each firm still has their “high” price but their output declines markedly. These firms realise that they each face a “relatively elastic” demand curve – such that they can cut the price they charge and the increase in revenue they experience will dwarf any increase in costs from having to produce more (especially as they will have capacity for this extra production, given that they were previously producing at an even higher level). So it is in the individual firms interest to decrease prices!
However, the firms in the industry realise that this incentive also holds for all the other firms. As a result, they know that if everyone acted on this incentive the demand that a specific firm faces would decline (as the price of substitutes would fall) and overall they would EARN LESS than if the whole industry kept prices up.
So we have a prisoner’s dillema, if the firms can co-operate and keep prices up they are all better off. However, there is the incentive for an individual firm to “deviate” by cutting prices.
As a result, we could be in a situation where, given the history of competition, firms in these industries are still “tacitly colluding”, and are thereby holding up prices in the face of falling demand.
When the Bank then tells people that prices are unfair, they increase the elasticity of the demand curve near the current price by even more – as people value “fairness” and they inform the consumer that things are unfair – this increases the incentive to deviate. Also, by doing so they make the firms feel bad – which further increases the incentive to deviate.
Once one firm has deviated, the collusion is likely to collapse like a pack of cards – as a result it may only take a small push by the RBNZ to get us from the collusive equilibrium to another equilibrium with lower prices and higher output.
This is my defense of the speech against the railing criticism I raised yesterday.
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