Bounded Rationality in Pricing under State-Dependent Demand: Do Firms Look Ahead, and if So, How Far?

Abstract

The authors propose an empirical procedure to investigate the pricing behavior of manufacturers and retailers in the presence of state-dependent demand. Rather than assuming that firms are perfectly forward looking and therefore solving accordingly for dynamic equilibriums that would arise in the presence of state dependence, the authors systematically evaluate whether boundedly rational firms indeed look ahead when they set prices and, if so, to what extent. They illustrate the procedure using household-level scanner-panel data on breakfast cereals and replicate the substantive results using data on ketchup. The authors find that (1) omission of state dependence in demand biases inference of firm behavior (i.e., tacit collusion is erroneously inferred when firms are competitive); (2) observed retail prices are consistent with a pricing model in which both manufacturers and retailers are forward looking (i.e., they incorporate the effects of their current prices on their future profits), but firms have short time horizons when setting prices (i.e., they look ahead by only one period, suggesting that firms are boundedly rational in their dynamic pricing behavior); and (3) even a myopic pricing model of firms that accounts for state dependence in demand is a reasonable approximation of the observed prices in the market.