One of the central areas where macro and microeconomics intersect is price behavior over the business cycle, especially in industries with market power. Are prices pro-cyclical (higher during booms) or counter-cyclical? The empirical evidence varies from industry to industry. Cement prices, for example, seem to be counter-cyclical. But many industries (most?) show cyclical prices. One story for this pattern is that collusion (tacit or explicit) breaks down during downturns because “weaker” players break away from the “agreement.” For example, most airfare price wars are started by airlines in financial distress, that is, desperate for quick cash.
Recent research by our Stern finance colleague Viral Acharya (together with Nada Mora of the Kansas City Fed) shows that, during the 2007-09 crisis, banks facing a funding squeeze (or exposed to liquidity demand shocks, or with weak balance-sheets) sought to attract deposits by offering higher rates. This is similar to what we observe in industries like airlines (where we think of a high interest rate as similar to a low airfare). An additional parallel is that more aggressive pricing by “weak” players seems to drag along “stronger” players, resulting in an industry wide “price war.”
Posted by Luis Cabral