A Theory of Price Rigidities when Quality is Unobservable.

A theory of price and quantity adjustments, in response to stochastic changes in demand, is developed for competitive mark ets. The level of demand is observable, but product quality is not. I t is shown that the higher the serial correlation of demand, the more rigid are prices and the greater the change in outputs. If the corre lation is low, prices are less rigid than when quality is observable; if it is high, they can be more rigid. Even with downward demand and upward sloping supply curves, prices can be completely rigid. Copyright 1988 by The Review of Economic Studies Limited.