JOrDaN MELMIES

New Keynesians versus Post Keynesians on the theory of prices

Abstract: The aim of this paper is to compare New Keynesian and Post Keynesian economics on the theory of prices. In the past two decades, there has been a revival in explanations of price rigidity with the emergence of the new Keynesian economists. These economists try to explain the price stickiness that all of the empirical studies on the topic confirm. This paper takes up the question of whether these study findings are compatible with the Post Keynesian theory of prices. On a deeper level, the paper explores the compatibility between the new Keynesian and Post Keynesian theory of prices. Key words: auctioneer, new Keynesian economics, Post Keynesian economics, price theory, sticky prices.

That the price of linen and woollen cloth is liable neither to such frequent nor to such great variations as the price of corn, every mans experience will inform him. This quotation from adam Smith, cited by robert Gordon (1981, p. 493), illustrates that the price adjustment problem is one of the oldest issues in political economy. recently there has been a revival of interest in price rigidity among both academics and practitioners. In academia, this renewed interest came from the emergence of the new Keynesian economists. New Keynesian economics was developed in the early 1980s as a response to the new classical macroeconomists, who reproached Keynesian models for not providing microeconomic justification for price rigidity. The aim of new Keynesian economics is thus to ground price rigidity in microeconomic terms so as to explain the nonneutrality of money in the short run and thus the existence of real effects (output fluctuations) following nominal shocks. among practitioners, the revival of interest took the form of empirical studies by several
Jordan Melmies is a Ph.D. candidate in the Clers research Department, at the University of Lille. The paper benefited from comments from Marc Lavoie, Frederic Lee, andrew archibald, Thomas Dallery, Laurent Cordonnier, and Franck Van de Velde. The usual caveats apply.
Journal of Post Keynesian Economics / Spring 2010, Vol. 32, No. 3 445 2010 M.E. Sharpe, Inc. 01603477 / 2010 $9.50 + 0.00. DOI 10.2753/PKE0160-3477320308

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of the worlds central banks. The first such empirical work, conducted in the 1990s by academic researcher alan Blinder (1991), had surprising findings. Several central banks decided to conduct similar studies for their own countries. The results were unanimousprices are sticky. New Keynesian economists developed several theories to explain this stickiness. One of the best known is the theory of menu costs, but a number of other theories have appeared such as implicit contracts, coordination failures, and nominal contracts. a careful look at this new Keynesian story, however, shows that these economists have in fact gone far away from Keynes. They have often been taken to task for this by Post Keynesian writers who try to remain faithful to Keyness original precepts. Nevertheless, Lee and Downward (2001), reviewing the seminal work of Blinder et al. (1998), concluded that empirical results could be interpreted within a Post Keynesian framework. Lee and Downward (2001) argued that this work was close to Post Keynesian economics, even if some incompatibilities persisted. This paper extends the analysis to all empirical studies conducted since 1998, and shows that although the Post Keynesian theory of prices has been further substantiated, the incompatibility between new Keynesian and Post Keynesian economics persists. New Keynesian economics: sticky prices The revival of Keynesian economics During the 1990s, there was a resurgence of economists labeling themselves Keynesiansthe new Keynesians. romer (1993) sees the Keynesian revolution in light of two fundamental issuesthe existence of involuntary unemployment and the role of demand in short-run economic fluctuations. after World War II, the dominant neoclassical synthesis relied on a fixed nominal wage/price assumption to explain the effect of stimulating demand policies. This short-run price fixity was fundamental to the neoclassical synthesis. But it collapsed in the 1970s in the face of new classical economists who found no rational, theoretical basis for such an assumption. To these economists, assuming that prices do not adjust to demand and supply disequilibria is the same as assuming that agents do not achieve trade gains or, as robert Lucas would often say, that they leave $500 bills on the sidewalk. This critique was devastating for Keynesian models, because it exposed their incompatibility with microeconomics (Ball and Mankiw, 1994). The following years were therefore devoted to market-clearing modeling, because for new classical macroeconomists, the economy is always and

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everywhere at equilibrium. However, they had buried Keynes1 a bit too fast, forgetting one detailthe empirical evidence on price rigidity. at that time there existed some studies, however old, that suggested the rigidity of prices (see Lee, 1998, for a detailed view of all these studies; see also Downward, 1999). Some authors, still believing in the rigidity of prices, considered the new classical critique less a funeral oration than a call to arms. Instead of rejecting the theory for the weakness of its microeconomic foundations, they tried to derive price rigidity from agents rational behavior. and new Keynesian economics was born. The revival of Keynesian economics is thus linked to the answer these authors gave to new classical macroeconomists. as often stated by Mankiw, it is an answer to Lucas. In other words, new Keynesian economics is the art of finding Keynesian results in a new classical framework. The new Keynesian theories of prices This section attempts to give an overview of the new Keynesian theories of prices. I will only expound the story of these theories within the new Keynesian paradigm, even though, as will be mentioned later, some of these theories were discussed well before the appearance of the new Keynesians. The starting point of new Keynesian theories of prices is imperfect competition. These economists have a clear picture of market structure: perfect competition would force firms to accept the market price as given, and all firms would thus be price takers. as soon as one departs from perfect competition, firms get some market power, and are thus able to become price makers to varying degrees. Now, if we can observe price stickiness and price-setting behaviors (i.e., firms are price setters), it means that markets are imperfectly competitive. For new Keynesians, firms are often oligopolists, monopolists, or competitive monopolists. The standard model is by Blanchard and Kiyotaki (1987). We are thus in an imperfectly competitive framework where firms set prices at a higher level than marginal cost. But new Keynesian economists knew this was just a framework: introducing imperfect competition is not enough to make price rigidity appear. For this reason they developed several theoretical explanations to explain price rigidity. Grounding price rigidity at the micro level then gave them the ability to explain the nonneutrality of money in the short run: for new Keynesians, money has short-run effects because prices are sticky. In the quantity equation Mv = PY, M has an
1 robert Lucas, interviewed by Snowdon et al. (1994), claimed there was no point for students to read Keynes any more.

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effect on Y because P does not react in the short run. There is no indexation mechanism between prices and nominal variables, especially the level of nominal aggregate demand. To explain this lack of adjustment, the first and probably best-known2 theory is doubtlessly the menu costs theory, devised by Sheshinski and Weiss (1977) and popularized by Mankiw (1985). The purpose of this theory is to consider that firms face costs in changing their prices. When demand increases, firms do not push up their prices because the induced cost would be larger than the benefit. In order to sell their products, firms have to write prices on menus, catalogs, and tags they have to print, distribute, and implement. Changing prices whenever demand changes would be very costly. However, as noted by Gordon (1990), this theory was soon criticized on the basis that these kinds of menu costs are small. New Keynesian economists have thus had to show how the small costs of making price changes can have large macroeconomic effects (Mankiw, 1985). a second explanation proposed by new Keynesian economists is the theory of coordination failure. In this theory (Ball and romer, 1991; Cooper and John, 1988; Stiglitz, 1984), firms leave their prices unchanged in the face of a change in demand because they just do not want to be the first to do it. Firms do not want to start price wars, and they do not want to be the only firm to push up prices. The individual firm thus waits for the others to go first. In so doing, no firm changes its price, even if it would be socially optimal that every firm had changed its price. Price stickiness is due to the inability of firms to coordinate. Central to this theory is the notion of strategic complementarity, as developed by Cooper and John (1988), which refers to situations where one agents incentive depends positively on the actions of other agents in the economy. In Ball and romer (1991), one individual firms price flexibility will increase the incentive to price flexibility for others. In other words, facing a rise in demand, an individual firm may not raise its price if it expects other firms not to do so. Coordination failure thus leads to price rigidity. The third explanation surveyed here is the implicit contracts theory. as noted by Blinder et al. (1998), this theory was first developed to explain wage rigidity by azariadis (1975) and Gordon (1974). The first to apply this theory to prices was arthur Okun in 1981. The idea is that producers seek to build long-term relationships with customers and will not change the price too often because that would make customers begin
2 Mankiw explains on his personal blog that his 1985 paper on menu costs is one of his three or four most cited papers.

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to compare the different producers. Firms and customers make implicit agreements in order to stabilize prices; in Okuns words, they make invisible handshakes (1981). This led Okun to distinguish between two causes of rising pricesa rise in demand and a rise in costs. Customers consider the first as unfair and the second as fair. another theory new Keynesians explored is the nominal contracts theory. Introduced by Fischer (1977) and Taylor (1979), this theory states that price stickiness results from the fact that many firms do business on the basis of written, fixed-term nominal contracts. Whenever an individual firm uses this kind of contract, price cannot be adjusted to demand and supply disequilibria as long as the contract is in force. Price stickiness is here caused by a legal-economic constraint. This explanation may seem rather weak because firms can rewrite new contracts when the current contracts expire. But Blanchard (1983) pointed out that if firms are all engaged in revising their prices, though not at the same time, some inertia in the price level will be observed as well. This theory is obviously related to coordination failure theory, in that synchronization is at the heart of the problem. another theory that was developed is cost-based pricing. This theory in its basic form (prices respond to costs) is not new, but new Keynesians gave it a more fashionable flavor under the work of Gordon (1981), who tried to show that lags between cost changes and price changes are due to the existence of multiple stages in the production process and could lead to price inertia at the aggregate level. One more way to explain price stickiness is constant marginal cost. The basic idea is that if marginal costs are constant with the level of output, so are prices. as noticed by Blinder et al. (1998), it is further required that demand curves be isoelastic (so that movements along the demand curve do not change the elasticity of demand) and that shifts in demand curves do not change the elasticity of demand (i.e., all demand curves have the same elasticity). If all of these assumptions are met, one can easily deduce that prices will be sticky over the business cycle. Quite a few other theoretical explanations were put forth by new Keynesians, even if they had less success in academia. Without being exhaustive, one might list temporary shock theory (firms fear that a demand shock might be temporary and might reverse in the following period), the procyclical elasticity of demand (firms lose their less loyal customers during recessions, so a price cut would not stimulate sales), the link between quality and price (customers associate lowered price with lowered quality), information cost (getting the information about demand is costly), nonprice competition (producers compete on things other than

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price), and psychological price points (prices are set at particular points that are psychological, so it is difficult to change them). Empirical surveys New Keynesian research was very successful in the 1980s and thereafter. These studies gave birth to numerous empirical studies on the topic. Blinder (1991) was the first to try to investigate whether entrepreneurs could validate all of these theories. He initiated an empirical study for the United States based on questionnaires. The purpose was very simple: ask managers how they behave concerning price setting, but ask them in plain English. The results were surprising from the standard point of view, and several central banks in the world decided to conduct essentially the same study for their own countries. The first to follow Blinder was the Bank of England, in 1997, then the Bank of Canada. More importantly, the European Central Bank (ECB) recently decided to conduct such a questionnaire survey (along with an econometric investigation) for all the euro zone countries, under the name inflation persistence network (IPN). The methodology was similar in all locales: meet managers with pricing responsibility and ask them questions about reviewing prices (i.e., reconsidering the price of products) and changing prices (when a price change is in fact decided on), or the reasons for not changing prices in the face of a change in demand. The managers had to rank the theories of price stickiness in the order of their importance as reasons for keeping prices unchanged. I selected a number of variables and theories and compiled the results for 14 countries. One methodological problem with this is that the theories that were tested were not the same in all countries. For example, Blinder et al.s original study (1998) tested the constant marginal cost theory, but that was not the case in Spain or Canada. another difficulty that crops up in these studies concerns the method of rescaling to excluding no answers. However, the results seem, as shown in Tables 1 and 2, quite homogeneous. Table 1 presents a general set of data on price reviewing and price changing (the findings from the euro zone come from Fabiani et al., 2007). One of the most obvious outcomes of Table 1 is the confirmed existence of price stickiness. Whatever the country, these studies confirm the findings of the prior studies found in Lee (1998). Prices are rarely reviewed, and even more rarely changed. In most countries, firms review their prices at most four times a year, and change them once a year. Large portions of firms (except in Italy) engage in what is called time dependent price reviewing: they decide to reconsider the price of their products at regular intervals (from 20 percent in Luxembourg to 79 percent in the United

Table 1 Price reviewing and changing

Price reviewing frequency (times a year) Median 4 12 1 3 1 1 2 4 1 2 2 4 4 1 1 1 1 1 1 1 1 1 1 4 2 1 1 1 1 1 1 1 1.5 2 1 1 1 1 1 1 1 1 1 1 1 2 1 Mode Median Mode Price changing frequency (times a year)

Country

Number of surveyed firms

One change the previous year (percent) 54.2 27.0 37.0 51.2 29.8 40.3 56.8 28.0 46.3

Percent of timedependent reviewing 68.0 66.5 79.0 65.7 43.0 5.4 23.1 55.0 30.4 33.4 60.0 20.0 39.0

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Austria (2007) Canada (2006) United Kingdom (1997) Belgium (2005) Germany (2006) Italy (2004) Sweden (2005) Portugal (2005) Netherlands (2006) Spain (2005) United States (1991) Luxembourg (2006) France (2004) Japan (2000)

873 170 654 1,979 1,200 333 600 1,370 1,246 2,905 200 367 1,662 630

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Table 2 Theories of price stickiness

Canada (2006) 7 3 1 5 10 4 Spain (2006) 1 3 4 2 8 6 7 5 9 4 5 2 1 6 3 9 8 12 1 3 11 9 15 13 14 2 10 7 United States (1991) Luxembourg (2006) France (2004) 4 3 1 5 2 10 8 Japan (2000) 2 3 1 7 5 4 8 Mean rank 2.3 2.9 1.8 6.6 3.9 11.3 9.1 7.2 4.0 7.8 8.3 3 4 2 9 11 7 1 6 10 1 2 10 5 14 16 11 3 13 8 1 6 2 8 7 1 3 2 4 5 1 3 4 13 11 2 7 United Kingdom (1997) Belgium (2005) Germany (2006) Italy (2004) Sweden (2005) 1 5 7 2 12 10 4 11 9 Portugal (2005)

Austria (2007)

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Importance of theories (ranks) Implicit contracts Explicit contracts Cost based Temporary shocks Coordination failure Information cost Menu cost Nonprice competition Constant marginal cost Pricing thresholds Judging quality by price

1 2 3 9 5 6 7 8 10

Netherlands (2006)

Implicit contracts Explicit contracts Cost based Temporary shocks Coordination failure Information cost Menu cost Nonprice competition Constant marginal cost Pricing thresholds Judging quality by price

1 2 4 5 8 6 7 3

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Kingdom). Price reviews are always more frequent than price changes. Certain problems may be pointed outconcerning, for example, the sample sizes, the size of the firms surveyed, the fact that the studies were conducted in periods of considerable prosperity, or even that there may be a bias as between services and industries. all of these observations are correct, but the findings are always and everywhere homogeneous. Studies did not report any country, big or small, in a depression or not, that reported very different results from the others, suggesting that there is probably some kind of a common base of behavior for all firms. When we turn to the reasons firms do not change their prices when there is a change in demand, Table 2 clearly shows that the best-ranked theory is implicit contracts.3 This theory was ranked first in seven countries (and was not proposed in two countries). among the high-ranking theories, one finds explicit contracts, cost-based pricing, coordination failure, constant marginal cost, and even judging quality by price. The others (menu costs, nonprice competition, costly information, etc.) generally fared poorly. The big winner is thus implicit contract theory. at the opposite end, the great loser seems to be menu costs (as measured by popularity). Looking at the mean ranks in Table 2, one may ask why cost-based pricing is not considered the winner. It is simply because this theory was not tested in enough countries. Still, cost-based pricing does seem to be a strong challenger to implicit contracts. A Post Keynesian view of pricing behavior Let us now have a look at these pricing surveys through a Post Keynesian lens. Two questions beg to be answered: Do these results bring something to the Post Keynesian theory of prices (do they reinforce the Post Keynesian view on pricing behaviors)? and do these results lead to a reconciliation between new Keynesians and Post Keynesians or to a total rejection of new Keynesian economics? Price stickiness and the Keynesian project The first critique often addressed to these new Keynesian theories of prices concerns the use of the label Keynesian these authors make. at the beginning of this paper, I highlighted the theoretical battles that
3 Some results may differ from the ECB studies because I chose to distinguish between constant marginal cost and cost-based pricing (whereas the ECB did not), as these two theories are clearly not the same from a theoretical point of view (as costbased pricing can be used with nonconstant marginal cost).

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occurred during the 1970s and 1980s about the fixed-price hypothesis. It seems striking, from a Post Keynesian view, that authors labeling themselves Keynesians base economic fluctuations on price rigidity. If one follows Ball and Mankiw (1994), the empirical evidence of price stickiness is the best proof one can have for the nonneutrality of money in the short run. If prices were perfectly flexible, money would not affect output. But Keyness goal was precisely to demonstrate that money is nonneutral, neither in the short nor in the long run, regardless of whether prices are flexible. Davidson showed that Keynes aimed at breaking Says law, and at showing that supply does not create its own demand even if prices are flexible and competition is perfect (see, e.g., Davidson, 1992). Money and demand do not affect output because prices are rigid; it is just that because they affect output, prices are not the problem. actually, new Keynesians and Post Keynesians have two different conceptions of money. New Keynesians just believe that money arose from the disadvantages of a barter economy, and neutrality is one of its inherent properties. Neutrality would be fully and immediately achieved if firms were not constrained to keep prices unchanged by a number of things such as contracts and costs. But in the long run, this neutrality still prevails. Post Keynesians, for their part, do not believe in the neutrality of money. They assume a monetary production economy. Following Keynes, they often (but not always; see rochon and Vernengo, 2003) assume that money is a creature of the state (what is called chartalism). agents thus have to generate state money to pay taxes. But firms also have to borrow money from banks in order to finance the capital goods (and wage payments) required to achieve their production plans. Banks want to be paid back in (state) money. In a monetary production economy, entrepreneurs have to pay back banks (and pay taxes) by generating money from sales. In this view, prices are just the mechanism by which firms generate money for their own reproduction. In such a framework, prices have to be preplanned when money is borrowed. Entrepreneurs have a price in mind when they make their production plans, because the request for credit funding will be based on this preplanned price, which will enable them to pay the banks back. Supply arises on the basis of a preplanned price, so there is no reason to change that price every time nominal demand changes. Usefulness of price theory It was just explained that, for Keynes, price rigidity is not at the source of economic fluctuations. Economies could enter into depressions even with perfectly flexible prices and perfect competition. The question is then,

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if prices are that unimportant, why should Post Keynesian economists waste time studying firms pricing behavior? The first answer often suggested is based on Lawsons (1997) wellknown notion of critical realism. Post Keynesians insist that economic theories require abstractions based on realistic assumptions. The models have to be built on real, observed behaviors of economic agents, not on some kind of theoretically conceived assumptions. The distinction here is the one made by Lavoie (2006) about the epistemology of heterodox schools compared to mainstream schools. Whereas mainstream schools rely on instrumentalism (the point of an assumption is to be able to make predictions), Post Keynesians emphasize realism. One could add that realistic assumptions are not the converse of predictions, because it is reasonable that the more realistic your assumptions, the more you are able to make predictions. Studying prices may thus be a matter of empirical realism; in Keyness theory, prices can be flexible or rigid. Their rigidity plays no role in effective demand effects, but for the purpose of realism, I choose to analyze prices that slowly respond to demand, because that is what is observed. The other value of price theory is that it leads to a totally different conception of the development of markets. If one realistic assumption has to be made, it is certainly not the rigidity of prices. Post Keynesian economists cannot simply assume the rigidity of prices. It has to be explained. It cannot be explained by neoclassical tools, for the reasons detailed by Lee and Keen (2004). If one assumption has to be made, it is the absence of an auctioneer. The absence of an auctioneer is the realistic assumption in the problem. That is, most markets are not centrally organized, and transactions can take place with or without equilibrium. Markets thus exist only through the existence of sequential transactions (Lee, 1998). a second assumption is the fundamental uncertainty in which firms have to act. Post Keynesians have long insisted on this: firms act in a nonergodic world (Davidson, 1996). Coupled with historical time, this means that firms have to make irreversible decisions with totally blurred vision. How can firms sell products in such a world? The answer is that firms have to define policiessuch as investment policies, employment policies, and especially here pricing policies. Policies are the answer to uncertainty. I am thus endorsing Heiners (1983) view that fundamental uncertainty leads people to rely on stabilizing behaviors and stabilizing conventions and institutions. Firms have to post a price, or administer a price as Gardiner Means (1935) used to say. To post a price, they add a profit margin to a measure of costs. This is the essence of the term price policy. The world in which firms have to act explains

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why firms simply desire stable prices; why they keep prices unchanged for a certain period of time or for several transactions. Flexibility would increase the risk of going bankrupt, as accepted by Keynes (1939) and further developed by Davidson (e.g., 1994). Saying this does not mean that prices do not change, but that they change infrequently or with a delay. Furthermore, stability is not strictly the same as rigidity. rigidity means that prices respond slowly to demand. However, if firms post prices that remain unchanged for a year, as seems to be the case, we can deduce that these prices are rigid (unless one supposes demand changes only once a year).4 While rigidity does not imply stability, stability does imply some kind of rigidity. The fundamental usefulness of price theory comes in once one understands that acknowledging that firms use pricing policies leads inevitably to a theory of the profit margin, which is a key variable in distribution theory, a fundamental issue in Post Keynesian economics. One could answer that new Keynesians acknowledge a profit margin added to costs, too. However, they only acknowledge it as it fits into imperfect competition. actually, when New Keynesians speak of price-making firms, they only do so with reference to monopolists or oligopolists. For them, if perfect competition assumptions were achieved, firms would then be unable to set prices; they could only accept the market price. If observation suggests that firms set prices and leave them unchanged for a time, it is because competition is imperfect. But imperfect competition does not mean that firms are price makers, strictly speaking. In the case of monopoly, the firm has the power to sell its output at a price that is larger than marginal cost. But, in this case, the firm is more a margin taker than a price maker. The market structure enables the firm to achieve a unit profit, but the firm has no decision to make about the value of the margin, which depends on the price elasticity of demand. Firms do not make prices; they take margins once the market structure has been set. The price does not come from adding a profit margin to a measure of costs, but the margin is the difference between the price and unit costs. In new Keynesian economics, firms do not have pricing policies at all. But in the real world, price setting is linked to the organization and centralization of markets and not to competition. real markets (i.e., without auctioneers) force firms to make prices, and that represents a big difference from new Keynesians.

Blinder et al. (1998) briefly discuss this question.

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Analyzing pricing behaviors In addition to the fact that these authors present all these theories as innovations, thus strangely never quoting the work of Joan robinson, whose Economics of Imperfect Competition (1933) had already aired the problem of constant marginal cost, the link between quality and price, or isoelastic demand curves, or the 1939 paper from Keynes that discussed cost-based pricing, there is one question that has to be addressed to new Keynesian economics. Why should price stickiness be only an undesired feature for firms? New Keynesians view the empirical findings of surveys merely as the consequence of a constraint that prevents firms from changing their prices. When there is an increase in demand, the firm would like to change its price but does not due to costs and constraints. But for Post Keynesians, there is a dimension of free will surrounding these pricing behaviors. Means (1935) long ago emphasized this notion of free will in his work on administered prices. His work was based on an administrative control on prices by firms and a deliberate choice to maintain the price for a certain period of time. Meanss work was really seminal but, as noted by Lee (1999), was made totally invisible to the profession by Stigler and Kindahls 1970 attack on Means for stressing the nonoptimizing behavior of firms. This attack in fact allowed new Keynesians to rediscover inflexible prices in an optimizing framework (ibid.). If firms act as Means conceived, it means that they do not seek to maximize profits. Their objectives are much more complex and varied. as was noted by Lee and Downward (2001) concerning Blinder et al.s (1998) work, in the mainstreams view, firms objectives are not a key issue because they are just supposed to optimize. But the data strongly suggest that firms simply do not act that way (Lee and Downward, 2001). In the Post Keynesian tradition, there is a theme that firms seek to achieve reasonable amounts of profits, and thus have to engage in sequential transactions to generate money. This view may explain some other findings that are in the studies. actually, if costs, contracts, coordination failure, and other things prevent firms from changing their prices when demand changes, they never do any such thing when costs increase. Many empirical studies have actually asked firms the driving factors leading to price increases and decreases. The answers were compiled from the ECB studies and from some other countries. Once again, the methodology was not everywhere the same (especially concerning financial costs), but I tried to group answers so as to get a representative table. The purpose was to rank different causes of changing prices, from first rank to fifth

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Table 3 Factors driving price increases

Labor cost Belgium Germany Spain France Italy Luxembourg Netherlands Austria Portugal United Kingdom Canada Sweden Mean 1 2 2 2 2 1 1 1 2 4 5 2.1 Material cost 2 1 1 1 1 2 2 1 1 2 2 1.5 Financial cost 4 5 5 5 2 5 5 5 4 5 4 4.5 Demand 5 3 4 4 4 4 4 4 4 3 3 3 3.8 Competitors price 3 4 3 3 3 3 3 3 3 2 1 1 2.7

rank. I give a mean in order to have a total outcome even if the number in itself is meaningless. The results are shown in Tables 3 and 4. as can easily be seen, demand is never the first factor driving a price change, be it a higher or lower demand. a rise in demand is ranked fourth for price increases, and a fall in demand is ranked third for price decreases. There is thus an asymmetry, but demand is never the best reason to change prices. Costs are always highly ranked. Labor costs and material costs are the two biggest causes for raising prices. Competitor pressure seems to be the best reason to cut prices, and demand is ranked third on that point. These results strongly suggest that a rise in demand does not jeopardize the targeted rate of profit, whereas a rise in costs clearly does. Conversely, a fall in demand threatens the firms ability to achieve the targeted rate of profit for the period, although the way to respond can be, but need not be, a cut in prices, as suggested by Downward and Lee (2001). Furthermore, a drop in material costs can lead to a drop in prices because the cut can be achieved while maintaining the same rate of profit. as one can see, in a simple Post Keynesian view of the behavior of the firm, price rigidity in the face of a rise in demand can be naturally derived without resorting to costs or contracts that prevent firms from changing prices. Post Keynesians can explain the rigidity of prices with simple tools, whereas new Keynesians need a lot of complex hypotheses to do so. If we assume, in a Post Keynesian view, that firms use some kind of cost-plus pricing and that the main reason for

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Table 4 Factors driving price decreases

Labor cost Belgium Germany Spain France Italy Luxembourg Netherlands Austria Portugal United Kingdom Canada Sweden Mean 4 4 4 4 4 3 3 5 2 4 5 3.8 Material cost 3 1 2 2 1 4 2 1 2 2 2 2.0 Financial cost 5 5 5 5 4 5 4 5 4 5 4 4.6 Demand 2 3 3 3 3 2 2 3 3 3 3 3 2.8 Competitors price 1 2 1 1 2 1 1 1 4 1 1 1 1.4

increasing prices is an increase in costs, this means that rigidity comes from profit margins more than from prices. The dynamics of profit margins would thus be composed of three distinct phases. For the reasons detailed before, firms set prices that they keep unchanged for a certain period. If costs increase during this period (i.e., in the short run), profit margins will decrease (first margin phase). after a couple of months or maybe one yearthat is, in the medium runfirms will push up prices in order to restore unit profit margins (second margin phase). and in the long run, unit margins can fluctuate under the influence of changes in the demands of workers and unions, or structural changes in competitive pressure (third margin phase). In such a framework, what can be said about all the theories focused on above? First, firms do not always support the theories as much as we may think. If we go back to Blinder et al. (1998), we will discover that the questionnaire survey was conducted in two steps: the theory was explained in plain English and then the question, Does it concern your company? was asked. If the answer was yes, the question How important is it in slowing down price adjustment? was then asked. The findings for these two questions are given in Table 5. It is plain that all of these theories are far from universally validated by entrepreneurs. Forty-three percent of firms are concerned by menu costs, 22.5 percent by the link between quality and price, 64 percent by implicit contracts, 60 percent by procyclical elasticity, 40.5 percent by

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Table 5 Acceptance of theories (in percent)

Very important 23.6 28.3 4.3 9.7 38.8 22.2 16.8 42.4 31.0 13.6 22.7 6.3 21.5 18.0 18.9 14.3 19.4 25.9 13.3 9.7 8.0 12.8 13.3 15.0 9.8 10.6 12.9 Moderate importance Minor importance Totally unimportant 49.5 39.3 81.5 55.9 30.0 43.9 59.3 27.5 30.2

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Acceptance ratio

Nominal contracts Implicit contracts Judging quality by price Procyclical elasticity Cost based Constant marginal cost Menu costs Coordination failure Nonprice competition

64.0 22.5 60.0 40.5 43.0 77.0

Source: Blinder et al. (1998).

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constant marginal cost, and 77 percent by nonprice competition. But being concerned by one of these theories does not imply that it prevents firms from changing prices. If one looks further into the importance of the theories, one will be surprised by the percentage of firms saying that the theory (whatever theory) is totally unimportant in slowing down price adjustments: only 27.5 percent for coordination failure, but 59.3 percent for menu costs, 55.9 percent for procyclical elasticity, 49.5 percent for nominal contracts, and even 81.5 percent for judging quality by price. Table 5 shows that implicit contracts are in fact responsible for sticky prices in only 32 percent of firms, constant marginal cost in only 16 percent of firms, and nonprice competition in 43 percent of firms. Entrepreneurs report that being concerned by one of these theories (facing costs of changing prices, producing at constant marginal cost, building long-term relationships, and so on) does not mean that it prevents them from changing their price. One other thing to say from a Post Keynesian point of view would certainly be that inversed causalities, as Post Keynesians like to put it, cannot be ruled out. Concerning, for example, menu costs, which were one of the first new Keynesian explanations of price stickiness, it seems to me that there can be several objections. First, as noted by Gordon (1981), some prices posted on tags can change every day, and menu costs never prevented inflation from occurring (ibid.). Furthermore, the growing use of electronic tags and the development of online sales, where prices can be changed in a second without a cost, altered nothing: firms still keep prices unchanged for a certain period of time. The final question is thus: Why in the world do firms post prices on tags and menus if doing so is such a restriction on their optimal plans? The Post Keynesian answer would be that causality has to be inversed: prices are not rigid because they are printed on menus; they are printed on menus because firms want to hold them constant for a certain period of time. Something similar could be said about nominal contracts. as can be seen in Table 5, 49.5 percent of firms found these totally unimportant in slowing down price adjustment in Blinder et al.s work. However, this theory seems to be well ranked in all countries. But, as conceded by Blinder et al., some economists would argue that this idea is not a theory at all, for it fails to explain why parties enter into such contracts in the first place (1998, p. 129). Post Keynesians do have an answer to this question: nominal contracts are a response to radical uncertainty. People and firms want to keep from going bankrupt (see, e.g., Davidson, 1994) and so they try to stabilize monetary flows. Stable prices and nominal

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contracts are thus two ways of coping with uncertainty, allowing for stabilized expectations. as to coordination failure, one question persists: If firms will not change prices because they fear competitors might not do the same, will all firms stay in that state? Wont they change their prices sooner or later? (See interview of Paul Davidson by John E. King, 1995.) What will make one firm begin to raise its price? The Post Keynesian answer usually is that firms will coordinate a solution at the level of the market, using unions, cartels and agreements (saying that cartels are forbidden does not mean they no longer exist), or even price leadership and price following. another means of coordination is to rely on conventions or traditions (Lee, 1998). at this point, I focus on one particular type of conventionnamely, a time convention. There is one country in which evidence suggests that some firms rely on a time convention to cope with problems of coordination. The study concerning Portugal (the only country where a question about the distribution of price changes was asked) reports the monthly distribution of price changes. In Figure 1, it appears that about 45 percent of firms change their prices in January. This could confirm that (historical) time is crucial in economic activity. Time is subdivided into several periods (years, months, and weeks) and the year is usually the period firms refer to in their operations and accounting. as the prices of goods and services are related to the profitability and production plans of firms as discussed below, it is not surprising that firms base their price decisions on the same time subdivisions, such as the year, to settle their pricing behavior. as for implicit contracts, this is one of the theories where Post Keynesians could most agree with new Keynesians. arthur Okun is indeed an often cited author in Post Keynesian articles, for his distinction between auctioneer markets and customer markets is the same as the distinction between Walrasian and non-Walrasian markets adopted below. This theory is interpreted as a preference of consumers for stable prices. But, as sometimes noted by new Keynesians, the theory does not explain why firms fail to perceive that by adjusting their prices, they would lose during a rise in demand what they would gain during a fall in demand. In a Post Keynesian view, the preference for stable prices needs to be extended to firms that want stable prices so as to cope with uncertainty, as previously discussed; but the question could be posed whether consumers have a mere preference for stable prices or, instead, a real need for them. Within historical time, it has to be thought that consumers just need stable prices to establish their repetitive and sequential consumption plans.

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Figure 1 Monthly distribution of price changes in Portugal

Source: Martins (2005).

The theory of cost-based pricing is also something that was highlighted long ago by Post Keynesian authors. Even if this theory ranks high, Post Keynesian economists would not see it as a barrier to price adjustment. To the contrary, it strongly suggests that firms react not to demand but to costs; they change their prices only when costs change. aiming at achieving a certain amount of profit, firms use pricing policies and react only when costs are affected. Cost-based theory is not a barrier to price adjustment but a suggestion that in non-Walrasian markets, the reaction of firms to demand is contingent. Conclusion To conclude, I resubmit the question Lee and Downward (2001) asked about the seminal work of Blinder et al. (1998). Do these studies substantiate a Post Keynesian theory of prices? as was shown, the answer may be affirmative, but one has to relinquish the new Keynesian paradigm of optimizing agents in ergodic worlds. The rigidity/stability of prices is a phenomenon that can be naturally derived from Post Keynesian assumptions, whereas new Keynesians (or mainstream Keynesians) have to imagine complex mechanisms to derive this price rigidity. The question of whether new Keynesian price theory is compatible with Post Keynesian theory can be settled. although both might agree on some theories, it is not possible to reconcile the two. Post Keynesians do not believe that prices are responsible for effective demand effects. The two paradigms refer to incompatible frameworks. Whereas in the new Keynesian conception, the optimization of the firm and its rationality

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still prevail, Post Keynesians refer to a limited rationality where agents, rather than maximize profits, adopt a targeted rate of profit. But, furthermore, it is the need for a renewed conception of the link between prices and competition that emerges. The concept of pricing policy contains in itself the foundations of an extended theory of competitionthat is, a theory of competition without auctioneer, where neoclassical conclusions become a special case of the theory of competition. Competition in a decentralized market differs from imperfect competition. Firms can adjust by trying to report the constraint of competition on workers, or even on smaller firms, so as to maintain their profit margins, which might have very damaging consequences for the economy as a whole. Ensuing policy recommendations would be very different from what is commonly admitted, even among Post Keynesians. RefeReNCes
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