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RAPPORT

I will survive

Pricing strategies of financially distressed firms

Non-technical summary

In recent decades a substantial amount of theoretical and empirical research has addressed the issues of how prices and margins vary over the business cycle and what are the driving forces behind their movements. Economists have searched for reasons why prices are kept relatively high in times of low demand and vice versa. Renewed attention gathered pace in the aftermath of the Great Recession, when the sharp fall of economic activity in many advanced economies was accompanied at least in the first stages by only a mild decrease in inflation.

In the model by Chevalier and Scharfstein (1996) the countercyclical behaviour of prices originates from the interaction between customer markets (characterized by stable relations between sellers and buyers) and financial restrictions: when demand is low, firms that have lower cash flow and face greater difficulty in raising external funds may set higher prices (or margins), exploiting their long-term customer relations to maintain short-term profits at the expense of future market shares. This paper extends the model by Chevalier and Scharfstein (1996): Örst, by allowing for some degree of demand persistence, and second, by assuming that the elasticity of demand is higher in booms than in recessions.

Typically firms perceive stronger competition during expansions than in downturns, as in recessions customers are less willing to bear search costs since they intend to buy a smaller number of units of a given good. We show that the countercyclical behavior of markups is strengthened if firms perceive demand to be highly persistent and the competitive pressures to have diminished with the downturn.

Our theoretical predictions are tested for Italy, via exploiting the dataset on firms' price- and wage- setting behaviour collected in 2014 by Banca díItalia in the context of the European System of Central Banks Wage Dynamics Network (WDN). Empirical estimates, referring to the period 2010-13, confirm that in a low demand environment, other things being equal, Italian firms with limited access to external finance tend to charge higher markups than unconstrained firms. Demand persistence amplifies the countercyclical behavior of markups, in particular in the services sector, while we find no significant effect of the degree of competition on markups. Results are also confirmed when we address the potential endogeneity of firmsíaccess to finance with respect to their profitability in an instrumental variables approach.

All in all, our findings suggest that, similar to the US and Spain during the Great Recession, in Italy the wide extent of financial constraints could have lain behind the sustained growth of prices in the 2010-2013 period, notwithstanding the slackness of economic activity.

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