Nominal Contracting and Price Flexibility in Product Markets

Abstract

The search for microeconomic foundations of non-Walrasian outcomes in labor and product markets has spawned many studies of contracting. This paper emphasizes the role of contracts for market equilibrium -- for many raw materials and basic industrial commodities -- in which long-term contractual arrangements and spot markets coexist. Our principal goals are two -- (i) to explain the existence of contracts and the equilibrium fraction of trades carried out under contract, and (ii) to consider the impact of demand and supply shocks on spot prices when market trades also take place through long-term contracts. We find that the relative importance of contracting depends on, inter alia, the variance of the spot price and the sources of underlying fluctuations. Consistent with the findings of previous macroeconomic studies, we find that contracting and price rigidity are more likely the more important demand shocks are relative to supply shocks. We adapt our static model of contract price and quantity determination to discuss the adjustment of contract prices. Finally, we discuss three important applications of our multiple-price modeling structure -- to (i) analyses of the effects of changes in vertical market structure on market equilibrium in commodity markets (with specific reference to petroleum and copper), (ii) models of the optimal degree of contract indexation,and (iii) aggregate studies of "sticky prices" in macroeconomics.