Exchange rates and oligopoly

The purpose of this paper is to explain empirical observations concerning t he impact of exchange rate changes on industrial prices. As exchange rates change the pass-through into industrial prices is often incomplete and some times it goes into the 'wrong' direction, i.e. the prices in the depreciati ng country decrease while those in the appreciating country increase. The l atter is called 'perverse pass-through'. The usual context for such observa tions is one of segmented markets and imperfect competition. We consider th e simplest model with these characteristics: Two duopolistic firms which bo th 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 restri ctions such as constant marginal costs are imposed, prices move in the 'rig ht' 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. (C) 1999 Elsevie r Science B.V. All rights reserved.