International Shocks, Variable Markups and Domestic Prices

How strong are strategic complementarities in price setting across firms? In this paper, we provide a direct empirical estimate of firms’ price responses to changes in competitor prices. We develop a general theoretical framework and an empirical identification strategy, taking advantage of a new micro-level dataset for the Belgian manufacturing sector. We develop a general framework and an empirical identification strategy to estimate the elasticities of a firm’s price response to both its own cost shocks and to the price changes of its competitors, without imposing strong structural assumption on demand, market structure, or production. Our approach takes advantage of a new micro-level dataset for the Belgian manufacturing sector, which contains detailed information on firm domestic prices, marginal costs, and competitor prices. The rare features of these data enable us to construct instrumental variables to address the measurement error in marginal costs, the simultaneity of price setting by competing firms, and correlated demand and cost shocks. We find strong evidence of strategic complementarities, with a typical firm adjusting its price with an elasticity of 0.4 in response to its competitors’ price changes and with an elasticity of 0.6 in response to its own cost shocks. Furthermore, we find evidence of substantial heterogeneity in these elasticities across firms. Small firms exhibit no strategic complementarities in price setting and complete cost pass-through. In contrast, large firms exhibit strong strategic complementarities, responding to both competitor price changes and their own cost shocks with roughly equal elasticities of around 0.5. We show that this pattern of heterogeneity in markup variability across firms is important for explaining the aggregate markup response to international shocks and the observed low exchange rate pass-through into domestic prices.

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