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Jordan Liang

Question 5
One of the key assumptions for the Keynesian model is that it only applies to
short-run periods during which firms do not change their prices. Instead, firms
choose to set a price for a period and react to consumer demand to avoid menu
costs that is costs associated with the changing of the prices. This assumption
also holds true for the short-run equilibrium output model which is the level of
output in which income equals to planned aggregate expenditure.
As stated earlier, one of the main reasons why firms choose to fix prices in the
short run is to avoid menu costs which result from price changes. Menu costs
vary for different sectors, for example costs for changing an item on a restaurant
menu include the printing of new menus and updating the prices on the POS
system. For the retail industry changes in price means retagging products and
updating prices in the computer. These costs are relatively small; however for
larger companies such as McDonalds, they may incur costs such as setting up
market surveys to determine the direction of price changes and getting
managers to develop new pricing strategies and later updating the menu boards
and advertisements notifying the public to their changes which may be time
consuming and costly. Generally for smaller firms, they would rather exist in
slight disequilibrium than to change their prices with every small shift in the
supply and demand for their goods and services- leading to price stickiness, the
situation where firms are resistant to change.
Another reason for price stickiness are explicit contractual agreements made
with customers to guarantee products to be sold at a specific price, a firms
attempt to build customer loyalty. Customers may enjoy this deal because it
lowers their transaction costs of going to different shops and finding the best
deal, they rather focus on the long-run average price rather than the spot rice.
Firms may also choose not to change prices because they want to follow the
crowd. This is because if only one firm increases prices then they may lose
customers and if only one firm lowers prices it may start a price war which is
detrimental to both the firm and its competitors profits.
Park, Rayner and DArcy have conducted surveys on behalf of the RBA to assess
the price setting behaviour in firms and the factors that influence these
decisions. The RBA survey states that 49% of firms are cost focused when
determining prices, that is a cost-plus method, where the price allocated is the
cost of producing the good plus a fixed or variable percentage mark-up cost.
When it came down to discounting, 40% of firms undertook some type of
significant discounting and 25% of firms discount as a result of fluctuations in the
business cycle. Larger firms were more likely to discount. Some other reasons
were to counteract competition from overseas exporters as well as other firms
using demand focused price strategies. 46% of firms review their prices annually
because they believed that the costs involved in frequently reviewing prices due
to changes in supply and demand outweigh the expected benefits of pricing their
goods and services at equilibrium. 40% percent of firms have changed their

Jordan Liang
prices in the 12 month period and 25% of firms changed their prices more than
once a month.
Firms more likely to change prices in the short run include the goods sector, with
larger firms changing their prices more frequently (more than once a week). This
is because smaller firms believe that the management and administrative costs
associated with price changes do not exceed the benefits of changing the price.
Firms that have imported input costs as a high percentage of their total costs are
also more likely to change prices than those whose imported input costs make up
a small section of their total costs. Retail sectors are most likely to change prices,
followed by manufacturing sectors and finally service sectors. Retail sectors can
change prices relatively easy, manufacturing sectors usually sell on a large scale
so increasing and decreasing prices has a large impact on its sales so it may
rather choose to sell goods at a constant price to avoid the risks involved in
changing prices. Finally an increase in price for a service, for example travel
agent costs may influence consumers to book online rather than spending
additional money for the service.