Pass-through and consumer search: An empirical analysis

Retail-price pass-through is one of the most important issues facing manufacturers of consumer packaged goods. Although retailers tend to pass higher wholesale prices through to consumers quickly and completely, they often do not pass on trade promotions. Currently, asymmetric pass-through is commonly thought to result from retailers' exercise of market power. Alternatively, it may be because of consumer search behavior and retailers' competitive response. We test this theory using a panel threshold asymmetric error-correction model applied to wholesale and retail scanner data for ready-to-eat cereal for a number of retailers in the Los Angeles metropolitan market. We find that consumer search behavior contributes significantly to imperfect pass-through. By allowing pass-through to depend on market power and consumer search costs, we find results that are contrary to the conventional wisdom. Namely, market power causes retail prices to fall quickly and rise slowly, whereas consumer search behavior causes retail prices to rise quickly and fall slowly - precisely the "rockets and feathers" phenomenon.