Market Position and Aggregate Price Dynamics

Abstract

This paper develops a general equilibrium framework for aggregate price dynamics incorporating industry competition and forward-looking rational expectations. It accounts for differences in pricing power across firms and allows for size-dependent shocks. The model builds upon a set of established facts. Industry leaders are usually much larger than other firms and charge a higher markup. They focus on preserving market share and their pricing behavior differs: they limit the pass-through of idiosyncratic cost shocks, but are strategic and match price changes by rivals. Meanwhile, trailing firms are generally much smaller and set prices monopolistically. On this basis, the framework yields several key results. First, due to strategic complementarity in pricing, the implied cost pass-through for industry leaders after an aggregate shock is around 25 percent higher than for an idiosyncratic shock, which aligns with evidence from Gödl-Hanisch and Menkhoff (2023). Second, aggregate shocks have an uneven impact across firms. Industry leaders and trailing firms face different demand schedules and adjust prices accordingly. In general, small firms appear more sensitive to the business cycle. Third, price competition within industries can significantly amplify the inflationary/deflationary effect of shocks to import prices with uneven impacts across firms. Finally, if a negative shock affects small firms more, industry leaders raise prices, resulting in `excess’ profits. In this case, the additional markup distortion amplifies the underlying shock by 25 percent.