Stochastic (s,S) Pricing and the U.S. Aluminum Industry

Abstract

In the typical (s, S) pricing model, some type of adjustment cost deters firms from frequently adjusting their nominal prices in the face of inflation. In this paper, frequent price changes act to reduce revenues rather than increase costs. The typical (s, S) model is additionally altered by making the inflation processes stochastic. A numerical technique is used to find the optimal pricing strategy for a firm in this situation. Data from the U.S. aluminum industry--an industry where demand conditions mirror the assumptions of the model--are then used to test whether actual pricing was similar to the model's predictions. Empirical results conform to theoretical predictions.