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Why Charities Can Have Strange Spending HabitsWill COVID-19 Lead to Lower Prices?
- By
- May 08, 2020
- CBR - Economics
The 2007–10 housing crisis vaporized up to $14 trillion of wealth in the United States, slashed the S&P 500 by 57 percent, and triggered 10 percent unemployment. Then―as now, during the COVID-19 pandemic―Congress mustered multibillion-dollar bailouts and the Federal Reserve bought trillions of dollars of bonds to lower interest rates and bolster the economy.
Yet something strange happened on the road to recovery: prices of goods and services didn’t plunge in the downdraft or soar in the rebound. Deflation shaved just a third of 1 percent off the Consumer Price Index in 2009, and over the following decade, inflation tiptoed back at just 1.8 percent a year, less than the Fed’s 2 percent target. Given the magnitude of the crisis and intervention, why was there such a relatively muted response in prices? And how might they move in the current crisis and beyond?
In search of an explanation, University of Maryland’s Luminita Stevens studied companies’ pricing strategies during the Great Recession. She finds that when navigating economic turbulence, companies didn’t respond in lockstep. Some tweaked prices frequently to match demand, and others were content to make fewer adjustments.
Stevens combed 10 years of weekly prices on food, beverages, health and beauty products, and other merchandise sold in 90 retail chains between January 2006 and December 2015. The data were collected from shoppers with bar-code scanners and compiled in the Nielsen Datasets at Chicago Booth’s Kilts Center for Marketing.
Stingier marketers protected themselves by maintaining higher prices—even in the downturn.
She finds that companies pursued three general pricing strategies. About 12 percent of products were governed by a single price policy (SPP), marked by small, infrequent price adjustments; fully 60 percent followed a policy of multiple rigid prices (MRP), with large, persistent price changes; and the remaining 28 percent chose a one-to-flex policy (OFP), which employs small deviations around a main price.
Products governed by each policy exhibited different inflation rates during the sample period, Stevens finds. While all three categories moved largely in unison at the beginning and end of the study period, they diverged during and immediately after the recession. For example, prices for SPP products continued to rise, while those for MRP goods fell by as much as 2.7 percent. This stands to reason, Stevens argues: makers of MRP products, which naturally face more-volatile, competitive conditions, are likely to lower prices further and faster in a downturn.
The differences in pricing strategies lie in how much companies were willing to pay to gather information and make timely calibrations, Stevens finds. Companies in highly competitive industries might have spent 5 percent of sales to stay abreast of markets, while other companies made do with less.
This mix of decisions helps explain why prices didn’t fall much in the recession. Stingier marketers protected themselves by maintaining higher prices—even in the downturn, Stevens finds. That’s because the “profit function is asymmetric,” she writes. Companies tended to generate larger profits by overpricing even at the loss of some sales than by underpricing and having to meet greater demand at higher cost. As a result, the less information companies collected about current market conditions, the more they tended to charge for products.
“Higher uncertainty makes the information problem more severe, generating even more overpricing,” Stevens writes. “Quantitatively, I estimate overpricing of between 2 and 5 percentage points.”
Stevens developed a model for generating optimal prices when companies don’t have the benefit of perfect market information. According to her model, SPP and MRP strategies generated 90 percent of the profits the companies would have earned with access to all the data.
To guard against volatility, MRP companies charged 4.5 percent more than a fully informed company in the same environment, while SPP companies added 2.9 percent, Stevens estimates. Whether consumers will subsidize the cost of that hedge in the COVID-19 recession remains to be seen.
Luminita Stevens, “Coarse Pricing Policies,” Review of Economic Studies, July 2019.
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