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Finance and Economics Discussion Series
Finance and Economics Discussion Series logo links to FEDS home page Sticky Prices, Coordination and Enforcement
John C. Driscoll and Harumi Ito

Abstract: Price-setting models with monopolistic competition and costs of changing prices exhibit coordination failure: In response to a monetary policy shock, individual agents lack incentives to change prices even when it would be Pareto-improving if all agents did so. The potential welfare gains are in part evaluated relative to a benchmark equilibrium of perfect, costless coordination; in practice, since agents will still have incentives to deviate from the benchmark equilibrium, coordination is likely to require enforcement. We consider an alternative benchmark equilibrium in which coordination is enforced by punishing deviators. This is formally equivalent to modeling agents as a cartel playing a punishment game. We show that this new benchmark implies that the welfare losses from coordination failure are smaller. Moreover, at the new benchmark equilibrium, prices are upwards-flexible but downwards-sticky. These last results suggest that the dynamic behavior of sticky-price models may more generally depend on the kind of imperfect competition assumed.

Keywords: Coordination failure, menu costs, monopolistic competition, cartel

Full paper (152 KB PDF)

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Last update: August 11, 2003