Exchange rates and oligopoly

Abstract

The purpose of this paper is to explain empirical observations concerning the impact of exchange rate changes on industrial prices. As exchange rates change the pass-through into industrial prices is often incomplete and sometimes it goes into the "wrong" direction, i.e. the prices in the depreciating country decrease while those in the appreciating country increase. The latter is called "perverse pass-through". The usual context for such observations is one of segmented markets and imperfect competition. We consider the simplest model with these characteristics: Two duopolistic firms which both operate in two countries. The markets of the two countries are separate and each of the firms produces its good in one of these countries. We study the effect of an exchange rate change on the prices in each country and on the level of sales and of profits of each of the firms. When strong restrictions such as constant marginal costs are imposed, prices move in the "right" direction in response to an exchange rate change. However, with general cost and demand structures, even in this simple model, it is possible for prices in both countries to move in "perverse" directions.