The economics of price adjustment

The benefits of price adjustment

Business firms have ample incentives to include some form of price adjustment mechanism in their contracts even if both parties are risk neutral. Firms do not generally enter into multiyear contracts because of their concern for the future course of prices. Rather, they enter into the agreements to achieve the benefits of cooperation. Having entered into such an agreement, the parties have to make some decision regarding the course of prices during the life of the agreement. That is, price adjustment will probably be ancillary to the main purposes of the agreement.

Price adjustment can be difficult and costly. Why then bother? Why not simply establish a price or a schedule of prices for the duration of the agreement? I will suggest four reasons that might lead business firms to consider using some form of price adjustment. First, if the contract concerns a complex product that will be continuously redefined during the life of the contract, a price adjustment mechanism can price the “amendments” to the original agreement. Examples include cost-plus pricing of sophisticated defense hardware and complex construction projects. Second, to properly coordinate their behavior, the parties want correct price signals. If the price of an input were below the market price (and if the buyer could not resell at a price greater than the contract price) the buyer would have an incentive to use “too much” of the input.