Scale Economies with Regard to Price Adjustment Costs and the Speed of Price Adjustment in Australian Manufacturing

The standard quadratic price adjustment cost function makes no allowance for firm size or for scale economies. Incorporating quadratic price adjustment costs into the profit function, a firm’s speed of price adjustment is both shown to be a positive/negative function of its size when firms have scale economies/diseconomies with regard to these costs and to be a negative function of market power. The intuitive explanation is that large firms that can defray this type of cost have less reason to slow price adjustment, while firms with market power are better able to offset price adjustment costs by slowing their speed of price adjustment. These results are used to derive an industry error correction model of pricing where the speed of price adjustment is a weighted average of the firm effects. Estimation of the model is carried out on data obtained from nine two-digit Australian manufacturing industries during the period 1994:3 to 2002:2. The empirical results suggest that the speed of price adjustment is positively related to the size of firms within an industry and negatively related to industry concentration. Given that these variables do not change rapidly over time, they are likely to have a steadying influence on the speed of price adjustment at an aggregate level in the face of changes to monetary and fiscal policy. JEL Classification: D21, L11, L13, L16, L60