A Theory of Monopolistic Price

Adjustment 1,2

ROBERT J. BARRO
The University of Chicago and Brown University

The theory of price adjustment has been dominated by the idea that prices rise in the

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presence of excess demand and fall in the presence of excess supply. In the simplest version
of this law of supply and demand, the rate of price change is directly proportional to the
amount of excess demand:
.! dP = k(Qd_Qj ...(1)
P dt
where, k is a positive constant. Such devices as an auctioneer and recontracting have been
introduced to rationalize this type of price-change mechanism. However, the distinctive
feature of this type of model is that variations in price are generated by the workings of the
" market" and are, therefore, separate from the actions of individual market participants.
Further, while demand and supply functions may be formulated in accordance with
maximizing principles, the mechanics of price change is essentially ad hoc, and seemingly
reflects no one's maximizing behaviour. 3
In general, optimal price adjustment depends on certain" institutional" characteristics
under which trading occurs; for example, the form of competition, the presence or absence
of trading devices such as an auctioneer, and the determination of which market participants
call out prices in the absence of a specific marketeer. While it would be an interesting study
to relate these market features to the underlying characteristics of goods and traders, the
present analysis abstracts from this type of question. The analysis focuses on a market
with one (monopolistic) seller and many (perfectly-competitive) buyers. The seller is taken
as the unambiguous price-setter, while the buyers are regarded as unambiguous price-takers.
Within this framework, the response of prices to " disequilibrium" emerges as the pattern
which maximizes the monopolist's conception of profit. In one sense this restriction to
monopoly is a limitation, since perfect competition and oligopoly should also be considered.
On the other hand, as Arrow [2] has pointed out, the existence of disequilibrium (excess
demand or supply) is inconsistent with certain assumptions of the perfectly competitive
model. In particular, the firm's assumption that it is confronted with a perfectly elastic
demand curve must be discarded in disequilibrium if the firm is ever to change price. In
this sense the response of prices to disequilibrium is essentially a monopolistic phenomenon
even if the individual units perform as perfect competitors in equilibrium. Therefore, it
1 First version received August 1970; final version received June 1971 (Eds.).
2 Earlier versions of this paper were presented at the Workshop on Lags in Economic Behaviour at the
University of Chicago, July, 1970; and at the Econometric Society Meetings, Detroit, December 1970.
I am grateful for helpful comments from Marc Nerlove and for research support from National Science
Foundation grant GS-3246.
3 This gap in standard analysis has been pointed out by Arrow [2, p. 43]; "[Equation (1) is] the well-
known' Law of Supply and Demand.' ... The Law of Supply and Demand may be a useful basis for inter-
preting some empirical phenomena ..• however, the Law is not on the same logical level as the hypotheses
underlying [demand and supply functions]. It is not explained whose decision it is to change prices in
accordance with [equation (1)]."
Similarly, Koopmans [6, p, 179] argues: "If ... the net rate of increase in price is assumed to be
proportional to the excess of demand over supply, whose behaviour is thereby expressed? And how is that
behaviour motivated? "
B 17
 18 REVIEW OF ECONOMIC STUDIES

seems clear that a theory of monopolistic price adjustment is a prerequisite to a general

theory of price adjustment.
While the principle motivation for this paper is a consideration of optimal price
adjustment, the formal analysis applies to a larger class of optimal adjustment problems.
The basic methodological approach may be outlined as follows. Abstracting from adjust-
ment costs, the optimal value (target) ofsome control variable X depends on some variable(s)
y: X d = Xd(y). If the actual value of X differs from X d, an out-of-equilibrium cost (per
period) results equal to: Z(Xd - X). In the price adjustment case, Z indicates the cost of
maintaining price so that marginal revenue departs from marginal cost. For the simple
model considered in Section I, the following important properties are satisfied: (l) Z has
a unique minimum point at X d = X, and (2) Z is symmetric in (Xd _ X) and increases
monotonically with I X d _ X I.
In addition to the out-of-equilibrium cost, there is some cost associated with adjust-

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ments of X (price). In this paper attention is limited to lump-sum adjustment costs. That
is, some cost is incurred each time an adjustment of price is made, but the cost is independent
of the amount or direction of adjustment.
Given the nature of the out-of-equilibrium and adjustment costs, optimal adjustment
of X depends on the anticipated future behaviour of the target, X d • In this paper target
movements are produced by shifts in demand, which are in turn generated by a symmetric,
stochastic process. In other words the decision-maker regards X d as, at least in part, a
temporary target, but he has no information on the direction of future change. Given the
adjustment cost specification, optimal adjustment behaviour takes a discrete form-either
make a discrete adjustment of X (so as to equate X to X d in the model being considered),
or make no adjustment. However, in a certain expected sense, optimal price adjustment
may be approximated in the form of equation (1). In this form the model determines the
(optimal) adjustment coefficient, k, as a function of underlying parameters.

I. STATIC OPTIMIZATION MODEL

A monopolistic firm produces a homogenous output flow Y. The cost of producing Y is
solely a function of current output:
COST = C(Y) (C'(Y»O) ...(2)
The possibility of storing up finished product as an inventory is omitted.'
The firm is aware of a downward-sloping demand curve for its product:
y d = Q(P)+u (Q'(P) <0) ... (3)
where, P is unit price and u is an additive term. The variable u is later treated as a stochastic
element which encompasses all price-independent (nonsystematic) variations in demand.
The firm maximizes profit, subject to its demand constraint":
Maximize: = PY- C{Y)
tt (4)
Subject to: Y= yd = Q(P)+u (5)
The first-order condition for a maximum is the equation of marginal revenue to marginal
cost:
P+ Q(P)+u = C'(y) ... (6)
Q'(P)
1 The firm's product may be viewed as a service which is immediately" perishable". The simultaneous
consideration of optimal inventory policy with optimal price-change policy appears to be a difficult problem.
2 Since 7T = P Y- C( Y), the optimum P for a given value of Y is the highest price which is consistent
with Y ~ yd = Q(P)+u. Since Q'(P)<O, this price is the one that just equates Y to yd. Therefore,
y = yd may be treated as an equality constraint in deriving interior maximization conditions.
 BARRO MONOPOLISTIC PRICE ADJUSTMENT 19

Equation (6), together with equation (5), determines optimal values of P and y.t
Returning to the demand curve of equation (3), it is of interest to examine the impact
of changes in u (nonsystematic variations in demand) on profit. Differentiating TC with
respect to u, and using equations (5) and (6):

dn = P_ C'( F)
du
If u is varied from an initial value, U o, to a final value, U 1, the corresponding change in
profit is:
UI(dn) lUI
[P-C ,(Y)]du
8TC(uo,Ul) =
fuo
- du =
du uo
where P and Yare constrained to satisfy equations (5) and (6) along the integration path.

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The evaluation of the above integral depends on knowledge of the functions, Q(P) and
C( Y). Since a general treatment is impossible, explicit functional representations of Q(P)
and C( Y) have been used. If Q(P) is a linear function in P, and C( Y) is a quadratic in Y
(or, more generally, if Q(P) and C( Y) can be satisfactorily approximated by linear and
quadratic functions, respectively, for the relevant range of values), the solution is straight-
forward. Using:
Q(P) = a- f3P (a, f3>0)
2 ... (7)
C(Y)= a+bY+cy (a, b>O)
and setting Uo = 0 and Ut = u, for convenience, the solution is2 :

8TC = (a-bf3) u+ 1 u2 ... (8)

(0, u) 2f3(1 + cf3) 413(1 + cf3)
The change of profit in equation (8) corresponds to a continuous adjustment of price
(and output) to variations in u. In order to derive the cost of being out of equilibrium, it
is necessary to compare the above change in profit to that which would occur if the firm
did not adjust price as u varied. Assume that price is fixed at a level which equates marginal
revenue to marginal cost for u = O. This" constrained" price, P, is determined from:

P+ Q(Pp) = C'( Y)
Q'( )
IY=Q(P)
... (9)
Given the price P, the firm selects a value of current output," t to maximize profit":
Maximize: it = Pf - C(f)
Subject to: f ~ yd = Q(p)+u.
Temporarily ignoring the demand constraint, the condition for optimal output (that is,
maximum output supply) is:
P = C'( Y) I Y = f m ax ... (10)

When the price level is fixed (at p), the monopolistic firm is willing to expand output until
1 The second-order condition for a maximum is:
Q'(P)[2- C"( Y )Q'(P)] + Q"(P)[P- C'( Y)] < O.
The attainment of an interior maximum is also subject to the condition that maximum profit be positive.
2 The second-order maximum condition is satisfied if cfJ> -1. The condition that profit be positive
is:
(rx-bfJ+U)2
7T = 4fJ(l +cfJ) -a>O.
3 No distinction is made between " short" and " long" run costs in the function, C( n, and future
levels of demand are assumed to be independent of the firm's current output decision.
20 REVIEW OF ECONOMIC STUDIES

price and marginal cost are equated.' The maximal output ( f max in equation (10» neces-
sarily exceeds the demand at U = 0, since the determination of P involved the equation of
marginal revenue to marginal cost at u = 0, and price exceeds marginal revenue (Q'(P) < 0).
Therefore, with a fixed price level, the firm responds to increases in u by meeting the extra
demand until marginal cost is raised sufficiently to equal price (such a point will exist only
if C"(Y»O over a sufficient range). Beyond this point (for as long as price remains fixed),
a portion of demand goes unsatisfied.
There also exists a minimum value of u, umin ' such that ft is negative for U ~ umin '
In this simple model, production is cut off entirely when u falls below umin •
If u can be guaranteed to lie within the range, umin ~ U ~ umu ' the demand condition
may be treated as an equality constraint (see footnote 1, p. 23). In this case f = yd,
together with equation (9), determines the price and output (1' and f) of a " fixed-price
monopolist".

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Writing ft = P Y- C( f) and using dP = 0, the change in profit with respect to changes
du
. U
In (flor Umin <
= U <
= Umax).IS:

~: = P-C'(y) I y = r-
The total change in profit induced by a change in U from Uo to Ut is:

M,<.....,) = t [P-C'(y) I y = y]du

= p(Ut-uo)-C(Y) y = Q(P)+Ul +C(Y) y = Q(P)+uo' I I

Using the forms of Q(P) and C( Y) in equation (7) and substituting Uo = 0, Ut = u, the
solution is:
Aft(o u) = (a- bf3) u-cu 2 • ...(11)
, 2p(1+cp)
Equation (11) gives the change in profit when price is maintained at the value corres-
ponding to U = 0, while equation (8) indicates the profit change when price is continuously
adjusted in an " optimal" manner. The" gain" from price adjustment is given by the
difference between these two expressions:
A A.6 _(1+2cp)2 2 _ (} 2 (12)
il1t(O, u) - il7L(O, u) - 413(1 + cp) u - u ...

( /I = ~~~~~~ > 0 if cp> -1, the second-order condition; Uml n:;; U ~ u_)
Equation (12) indicates the profit foregone (cost of being out of equilibrium) from not
adjusting price while demand has varied by an amount u. The cost is seen to depend on
the square of the" neglected" demand variation (u2 ) . The symmetry of this cost should
be emphasized. Because the cost of neglecting variations in demand depends only on the
magnitude of the variation, and not on the direction, the final price-change mechanism
turns out to be symmetric.
For a given amount of disequilibrium (u), the out-of-equilibrium cost decreases with
the price sensitivity of demand, /3, and (if the second-order condition, c/3> -1, is satisfied)
increases with the slope of the marginal cost curve (C'{F) = 2c).
1 In terms of output determination, the monopolist acts like a perfect competitor in .; disequilibrium "
(while P is fixed) since the connection between output and price is temporarily" neglected". This conclusion
may be contrasted with that of Arrow [2], who observes that perfect competitors must, with respect to price
decisions, act like monopolists in disequilibrium.
 BARRO MONOPOLISTIC PRICE ADJUSTMENT 21

II. OPTIMIZATION SUBJECT TO STOCHASTIC DEMAND

If price (and output) could be adjusted instantaneously at zero cost, and no delays in per-
ception were involved, it would be unnecessary ever to forego the profit indicated in
equation (12). As u (demand) varied, optimal policy would involve the necessary variation
in price in order to continuously maintain marginal revenue = marginal cost. However,
if some cost is attached to making changes in price, this cost should be weighed against the
cost of being out of equilibrium. The precise form of optimal policy depends on the nature
of the adjustment costs, as well as on the (expected) future behaviour of u (assuming that
the other functions and parameters are fixed).
Shifts in price involve direct administrative costs to the producer (seller) and they also
impose information costs on customers. Each time price is adjusted it is necessary for
buyers to learn the new price. This type of information and related search cost has been

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discussed by Alchian [1]. In terms of the model of Section I, information costs would be
transmitted indirectly to the producer by shifts in the demand curve. In particular, a firm
with a more variable price history is likely to experience a lower demand (smaller a in
equation (7» for any current price level. Therefore, any decision to change price should
consider the impact of this change on the firm's price" reliability" and, hence, on the level
of its demand curve.
The administrative costs associated with price changes are straightforward, and can
reasonably be described as a lump-sum amount, independent of the size or direction of
adjustment. For the purposes of the current analysis, it is assumed that the total cost
imputed to each price adjustment may be represented in this simple form; that is, a lump-
sum (dollar) amount, y. This form of adjustment cost leads to an optimal control problem
which can be solved analytically. However, since information costs are likely to be more
important empirically than administrative costs, it would be useful to extend the analysis
to include adjustment costs which operate indirectly through effects on the demand curve.
Variations in output are assumed to incur zero adjustment costs. The inclusion of
output adjustment costs would require a consideration of inventories and an explicit
treatment of factor adjustment costs. These considerations go beyond the scope of the
present paper.
The additive demand component, u, of Section I is treated as an observable random
variable which is generated by a symmetric random walk. The walk is regarded as having
zero origin, unit step size;' and a constant time interval between steps equal to T. Two
important properties of this stochastic process are absence of trend and serial independence.
In determining its price-adjustment behaviour, the firm is assumed to adopt a policy
of" (S, s) " form." In accordance with this type of policy, the firm selects ceiling and floor
values for demand (hc and -hf) at which price adjustments occur. For example, if u
attains the ceiling, the firm effectively revises its view of the demand function by adding the
amount hc. Assuming that the process originated at u = 0, the new " effective" demand
function after a ceiling hit would be:

... (13)
Subject to this revised view of the demand curve, the firm determines a new (higher) price
level (so as to equate marginal revenue to marginal cost) and maintains this price until
a new ceiling or floor hit occurs. For the linear demand function of equation (7), the

1 As long as the steps are of equal size, a unit step size may be chosen by taking the appropriate normal-
ization for output units. One problem with the random walk process is its nonstationarity. Modification
of the process to achieve stationarity would be useful, but it is not immediately clear how to proceed without
introducing other undesirable properties into the model.
2 Scarf [9] presents an optimality proof for the (S, s) policy form in a similar context. However, his
model constrains the stochastic movement to be in a single direction. Eppen and Fama [4J provide numerical
proofs for (8, s)-type optimality in two-sided stochastic models which are analogous to the one used in this
paper.
 22 REVIEW OF ECONOMIC STUDIES

addition of he to yg in equation (13) can be viewed as a shift in the constant term:

'OC l = OC o +h e •

Since the out-of-equilibrium cost (equation (12» is independent of oc (and, since "I is indepen-
dent of oc), the trade-off between adjustment and out-of-equilibrium costs is not affected
by this" revision" of the demand curve. Accordingly, the stochastic process may be
treated as though it were repetitive, with u returning to the origin each time an adjustment
in price (that is, «) occurs. It also follows that once optimal ceiling and floor values have
been found, these values remain optimal after future price adjustments have occurred.
Letting m denote the number of price adjustments which occur over some time interval
T, the total expected cost per unit of time may be written as (using equation (12»:

E -~~J
[
. - = y 'E(mjT)+E(An-Aft) = y 'E(mjT) + O'E(u2 ). ...(14)

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TIme
The firm is assumed to select ceiling and floor values (he and -hI) so as to minimize this
expected cost per time. 1 Since the out-of-equilibrium cost is symmetric in u, the optimal
solution is symmetric: he = hI = h. Given this symmetry, the essential problem is to
relate the expectations which appear in equation (14) to the choice of h. The solution
utilizes previous work of Feller [5] and Miller and Orr [7].
For a symmetric random walk with return point at zero and absorbing barriers at ±h,
the expected duration (expected amount of time between barrier contacts) is2 :
D = h 2 -r
where, -r is the amount of time per step. The expected number of barrier contacts (price
adjustments) per unit of time approaches liD as the planning horizon becomes large
[7, p. 421]:
1
E(m/T) ~ 1/ D = h2 -r'
The variance of the Bernouilli process involved in the symmetric random walk may be
derived as: q;
= tj-r, where t denotes the total elapsed time since the start (from the origin)
at time zero. 3 The" daily" variance is:
u2 = u;(t = 1) = 1.
-r
The parameter q2 may be viewed as a measure of variability of demand. The expected
adjustment cost per unit of time may then be written as:
Y'E(m/T) ~"Iq2Ih2. ...(15)
Note that a higher h reduces the expected adjustment cost per time.
The expected out-of-equilibrium cost is given from equation (14) as: O·E(u2 ) . E(u2 )
may be calculated by deriving the density function of u. The difference equation and boun-
dary conditions which determinef(u) are (using steady-state occupancy probabilities):
f(u) = t[f(u + 1)+f(u -1)] ( - h + 1 ~ u ~ h -1; u #: 0)
f(h) =f( -h) = 0
f(O) = !-[j(l)+f(-l)+f(h-l)+f(-h+l)]
h

II
L
=-h
feu) = 1.
1 The firm is assumed to be risk-neutral, hence, only the expected value of cost per time is considered,
If information costs (on customers) of price adjustments were included, the different attitudes toward risk
of firms and customers would become important.
2 This result follows with some modifications from Feller [5, p. 349J.
3 This "unconstrained" variance is derived independently of the barrier positions, and does not
correspond to E(u 2) , which is derived below.
 BARRO MONOPOLISTIC PRICE ADJUSTMENT 23

The difference equation can be solved to yield the density function:

H1-~) (O~u~h)
feu) = ...(16)

H ~)
1+ (- h ~ u ~ 0)
Using equation (16) and h ~ 1, E(u 2 ) is eventually determined as:
E(u2 ) ~ h2/6.
Therefore, the expected out-of-equilibrium cost is:

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eh 2
e'E(u 2 ) ~ -. ...(17)
6
Note that a higher h increases the expected out-of-equilibrium cost.
Using equations (15) and (17), total expected cost per time may be expressed as a
function of h:
~
2
E [cost] ')'0'2 + eh • . ..(18)
Time h2 6
The value of h 2 that minimizes this expected cost per time is":

e= (1 + 2CP)2). ...(19)
(fi)2 = a / : ( 4P(I+cP)
If a firm selects its critical ceiling and floor values for demand according to equation
(19), the reaction to changes in u (variations in demand) depends on the position of u
relative to ±Ii. If an increase in u produces a contact with the upper barrier, the firm will
react with a discrete upward shift in price. If u decreases sufficiently to reach -fi, an
equal size fall in price will occur. For intermediate variations in u which do not involve
barrier contacts, no price change will occur.
Although an individual firm's optimal price-adjustment behaviour is fundamentally
of this discrete decision type, some further insights can be gained by considering expected
price-change behaviour. Starting from (observed) disequilibrium u, consider the expected
price change which occurs over the interval up to (and including) the first adjustment of
price.
The probability of the random walk terminating at +Ii (therefore, resulting in an
increase in the firm's price), given that the walk originated at u, is [5, p. 345]:

Pr (+ fi) = ! (1 + ~)-
The corresponding probability of terminating at -Ii (reducing price) is:

Pr (- fi) ! (1- *)-

=

For the simple demand and cost curves that have been employed in this analysis (equation
(7», the corresponding discrete price changes are: ± Ii (1+2CP). Therefore, the net
2P 1 +cf3
The condition of Section I which guarantees that a fixed-price monopolist meets demand completely,
1
llmln ~
U ~ U maxo translates into: - Uml n ~ It ~ U maxo with It determined from equation (19). If the parameter
values are such that this last inequality is satisfied, the monopolist will, in fact, always meet demand.
24 REVIEW OF ECONOMIC STUDIES

expected price change at the first adjustment time (starting from u) is:

E(LlP) = -Ii - (1 2c
+ -(3) EPr (+h)-Pr (-h)]
A A

2f3 1 +cf3

=
2/1 1+c/1
l..(1
+ 2C(3) u. ...(20)

The expected duration of the walk which originates at u (average time to first price
adjustment) is [5, p. 349]:

Therefore, the expected price change per time up to (and including) the first price adjustment

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may be approximated by":
LlP )
( LlT
~ E(LlP) = (J2
Du 2/1
(1l+cf3
+ 2C/1) ~.
h 2
- U
2

If the initial disequilibrium is small relative to that value which would cause a shift in
price: I u I ~ Ii, one may approximate:

LlP )
( LlT
~ (J2
2P
(11+cj3
+ 2CP) ~
h
2
(I u I ~ Ii).
-
...(21)

Viewing " output supply" as the output corresponding to u = 0, u may be replaced by

current excess demand: u = yd_ ys. Substituting for li2 from equation (19) and dividing
both sides of equation (21) by P, one obtains":

fM)
!p\~ ~ uv«: YS)
k 0'(1 + 2cf3)2
= . ...(22)
4P.J 6y[P(l + cfJ)]t
In the above expression 0'2 is the" daily" variance of u (demand), y is the lump-sum price-
adjustment cost, f3 is the (constant) price sensitivity of demand, and c measures the (constant)
slope of the marginal cost function (C"(y) = 2c).
The expected price change behaviour described in equation (22) has the form of the
conventional law of supply and demand given in equation (1). However, it should be
stressed that equation (22) involves an averaging (over time) of discrete behaviour, so that
optimal price adjustment (at least at the individual firm level) cannot be accurately described
by a differential equation. An important feature of equation (22) is its symmetry. This
result derives from symmetry in the out-of-equilibrium and adjustment costs, and from the
symmetry of the stochastic demand process.

1 In order to calcu1ate (~~) exactly, it would be necessary to sum over an explicit expression for the

density of first absorption time. Unfortunately. this calculation does not appear feasible. Therefore, a
ratio of expectations has been taken as an approximation to the expectation of the ratio.
2 The presence of P in the expression for k in equation (22) may be interpreted by expressing the
nominal price-adjustment cost as: y = y*P, the demand sensitivity as: fJ = fJ*IP. and the cost coefficient
as: c = c*p. where P is the" overall .. price level. In terms of starred variables. the adjustment coefficient
is:
o{l + 2c*fJ*)2
k= .
4 (~) '\I'6y*[fJ*(1 + c*fJ*)]3/2

Therefore, the relative price. PIP, influences k, but proportional shifts in P and P (with fJ*, c*, y* fixed)
leave k unchanged.
 BARRO MONOPOLISTIC PRICE ADJUSTMENT 25

The coefficient of proportionality (k) between average price change per time and
excess demand is explicitly related to the parameters of the model.
1. The coefficient is positively related to the variance of demand, (J2. This result
emerges as the outcome of two offsetting forces. First, a larger demand variance implies
an increased frequency of price adjustment for a given ceiling value, Ii (equation (15)).
Second, this effect is partially offset by the positive relation between Ii and (J2 (equation
(19». The net effect is a positive relation between k and 0'2.
2. The coefficient is inversely related to the lump-sum cost of price adjustment, y.
3. The coefficient is inversely related to the price-sensitivity of demand, {3. A larger
demand sensitivity reduces the out-of-equilibrium cost (equation (12», and it also decreases
the size of the price adjustment which is necessary to re-attain " equilibrium". Both of
these effects tend to lower the responsiveness of price to excess demand.
4. The coefficient is positively related to c (given the second-order condition, c{3> -I)

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which measures the slope of the marginal cost curve (C"(Y) = 2c). This result reflects the
increase in out-of-equilibrium cost (equation (12» which accompanies a rise in C"(Y)_
Since this cost is raised, the firm is motivated to raise price more frequently (by reducing
Ii) and k is increased.

III. EXTENSIONS OF THE MODEL

I. An important extension of the model is the inclusion of anticipated trends in underlying
variables (such as, overall price level, costs, systematic demand shifts) which lead to an
expected trend in a firm's target price level. This modification would alter the form of the
average price change relation in equation (22) to include the anticipated trend of the target
price along with a measure of current excess demand.
2. In the model used in this paper, adjustment costs were assumed to be solely lump-
sum and symmetric. This set-up appears reasonable if one considers purely administrative
costs of price change, but information costs (which are actually transmitted to the firm
indirectly via shifts in the demand curve) may be more appropriately modelled by also
including costs which depend on the amount or the speed of adjustment. In the optimal
investment literature initiated by Eisner and Strotz [3; see, in particular, p. 69], speed-
dependent adjustment costs (for example, costs which vary with the square of the amount
of adjustment) were emphasized as the essential rationale for partial adjustment behaviour.
However, the incorporation of speed-dependent (say, quadratic) adjustment costs into the
current model does not alter the one-shot (bang-bang) adjustment behaviour which emerged
in Section II. The inclusion of costs which vary with the amount and/or speed of adjust-
ment (with symmetry retained) implies that discrete adjustment from the barriers, ±h,
should be made to non-zero return points, ± R, respectively; that is, the common return
point at zero disappears, but the basic form of adjustment is the same, as long as no indivisi-
bilities or " large" jumpiness in the stochastic process are introduced. A more complicated
adjustment cost function which does lead to partial (discrete) adjustment is the following:
lump-sum, decision-type costs are incurred at the initiation of adjustment, but these costs
do not recur as long as adjustment in successive periods is merely a continuation of the
original decision. Subsequent adjustment periods are characterized by another type of
lump-sum cost and also by speed-dependent adjustment costs. Under the above speci-
fication, adjustment will again not occur until the stochastic variable (u) reaches a critical
barrier (±h). At this point, adjustment will be initiated, but the return point (±R) will
not be attained in a single step. Rather, a finite number of periods will be used to move
from ±h to ±R, thus implying a form of partial adjustment. While this extended model
does lead to partial adjustment, the idea of a non-recurring decision cost may be more
applicable to optimal investment behaviour! than to optimal pricing policy. In any case
1 Asymmetry in the adjustment costs may also be appropriate in models of optimal capital accumu-
lation.
26 REVIEW OF ECONOMIC STUDIES

one-shot adjustment does not appear unreasonable for optimal price policy, though it
does appear unreasonable for optimal capital stock accumulation. It would, therefore,
be of considerable interest to apply a modified version of the model to the problem of
optimal capital accumulation.
3. Since the current price adjustment model is limited to the framework of monopoly,
it would be useful to generalize to a framework of oligopoly. This extension requires a
mechanism for allocating demand among different firms, and it also requires a specification
of firm interaction. Some developments along this line are contained in the papers in
Phelps [8], though these papers omit lump-sum adjustment costs, and therefore, do not
deal.with discrete adjustment behaviour.
In an oligopoly model it would be interesting to consider some measures of overall
price change by averaging over individual firm behaviour. It seems likely that individual
adjustment will still be of the one-shot variety, but average response may be describable as

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a smooth function. In other words the conventional law of supply and demand (equation
(1)) may well be satisfactory as an approximation in the aggregate, although it misses the
discrete response at the individual unit level.
4. Finally, the model could be usefully extended to include wage (factor-cost) adjustment
and to include optimal inventory holding along with optimal pricing policy.

REFERENCES
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Economic Journal (1969), 7, 109-128.
[2] Arrow, K. J. "Toward a Theory of Price Adjustment ", in M. Abramowitz, ed., The
Allocation of Economic Resources (Stanford, Stanford University Press, 1959).
[3] Eisner, R. and Strotz, R. "Determinants of Business Investment", in: Commission
on Money and Credit, Impacts of Monetary Policy (Englewood Cliffs, New Jersey,
1963).
[4] Eppen, G. and Fama, E. "Solutions for Cash Balance and Simple Dynamic Portfolio
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[5] Feller, W. An Introduction to Probability Theory and its Applications, Vol. I, 3rd ed.
(New York, John Wiley and Sons, 1968).
[6] Koopmans, T. C. Three Essays on the State ofEconomic Science (New York, McGraw-
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[7] Miller, M. H. and Orr, D. "A Model of the Demand for Money by Firms ", Quarterly
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[8] Phelps, E. S., et al. Microeconomic Foundations of Employment and Inflation Theory
(New York, 1970).
[9] Scarf, H. "The Optimality of (S, s) Policies in the Dynamic Inventory Problem ", in
K. J. Arrow, S. Karlin and P. Suppes, eds., Mathematical Methods in the Social Sciences,
1959 (Stanford, Stanford University Press, 1960).