How Much Do Prices Respond to Demand and Supply Shocks?

This paper presents a theoretical examination of price responses to movements in demand and supply where firms face either unwanted inventories or stockouts in each period. The response mechanism consists of two complementary motives that arise when operating under uncertain business environments. To an increase in demand, a firm has a motive to lower its price reflecting lower effective marginal costs but also has another motive to raise its price to rebalance expected marginal revenues associated with two distinct demand states, unwanted inventories and stockouts. These two motives cancel out each other at optimum, resulting in a limited response of prices to demand shocks. To a cost-push shock, the firm has a motive to raise its price reflecting higher effective marginal costs for a given output level and is further prompted to raise prices reflecting a higher expected value of unit inventory. The two motives push prices up in the same direction, resulting in a large response of prices to supply shocks.