Real rigidity

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In macroeconomics, rigidities are real prices and wages that fail to adjust to the level indicated by equilibrium or if something holds one price or wage fixed to a relative value of another. [1] :365 Real rigidities can be distinguished from nominal rigidities, rigidities that do not adjust because prices can be sticky and fail to change value even as the underlying factors that determine prices fluctuate. [1] :365 Real rigidities, along with nominal, are a key part of new Keynesian economics. [1] :378 Economic models with real rigidities lead to nominal shocks (like changes in monetary policy) having a large impact on the economy. [1] :379

Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of an economy as a whole. This includes regional, national, and global economies. Macroeconomists study aggregated indicators such as GDP, unemployment rates, national income, price indices, and the interrelations among the different sectors of the economy to better understand how the whole economy functions. They also develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, saving, investment, international trade, and international finance.

Nominal rigidity, also known as price-stickiness or wage-stickiness, is a situation in which a nominal price is resistant to change. Complete nominal rigidity occurs when a price is fixed in nominal terms for a relevant period of time. For example, the price of a particular good might be fixed at $10 per unit for a year. Partial nominal rigidity occurs when a price may vary in nominal terms, but not as much as it would if perfectly flexible. For example, in a regulated market there might be limits to how much a price can change in a given year.

New Keynesian economics is a school of contemporary macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of new classical macroeconomics.

Contents

In the product market

Real price rigidity can result from several factors. First, firms with market power can raise their mark-ups to offset declines in marginal cost and maintain a high price. [1] :380 Search costs can contribute to real rigidities through "thick market externalities". A thick market has many buyers and sellers, so search costs are lower. Thick markets can be expected to occur more often during booms, and they thin during downturns. If this pattern causes marginal costs to increase during recessions, thick markets can lead to real rigidities. [1] :380 "Customer markets" can also create real rigidities. In customer markets, firms take advantage of their market power and refuse to lower prices because they do not want to give customers an incentive to shop elsewhere and search for prices that are even lower. They would rather offer the customer a consistent price and have the customer consistently shop at their store. Also, customers will likely not notice a price cut as much as a price increase, giving the store less of an incentive to cut prices. [1] :381

In economics and particularly in industrial organization, market power is the ability of a firm to profitably raise the market price of a good or service over marginal cost. In perfectly competitive markets, market participants have no market power. A firm with total market power can raise prices without losing any customers to competitors. Market participants that have market power are therefore sometimes referred to as "price makers" or "price setters", while those without are sometimes called "price takers". Significant market power occurs when prices exceed marginal cost and long run average cost, so the firm makes economic profit.

Markup is the ratio between the cost of a good or service and its selling price. It is expressed as a percentage over the cost. A markup is added into the total cost incurred by the producer of a good or service in order to cover the costs of doing business and create a profit. The total cost reflects the total amount of both fixed and variable expenses to produce and distribute a product. Markup can be expressed as a fixed amount or as a percentage of the total cost or selling price. Retail markup is commonly calculated as the difference between wholesale price and retail price, as a percentage of wholesale. Other methods are also used.

Marginal cost factor in economics

In economics, marginal cost is the change in the total cost that arises when the quantity produced is incremented by one unit; that is, it is the cost of producing one more unit of a good. Intuitively, marginal cost at each level of production includes the cost of any additional inputs required to produce the next unit. At each level of production and time period being considered, marginal costs include all costs that vary with the level of production, whereas other costs that do not vary with production are fixed and thus have no marginal cost. For example, the marginal cost of producing an automobile will generally include the costs of labor and parts needed for the additional automobile but not the fixed costs of the factory that have already been incurred. In practice, marginal analysis is segregated into short and long-run cases, so that, over the long run, all costs become marginal. Where there are economies of scale, prices set at marginal cost will fail to cover total costs, thus requiring a subsidy. Marginal cost pricing is not a matter of merely lowering the general level of prices with the aid of a subsidy; with or without subsidy it calls for a drastic restructuring of pricing practices, with opportunities for very substantial improvements in efficiency at critical points.

The complexity of the "input-output table" can also lead to rigidity. Decentralized global supply chains lead to many firms competing for the same inputs and producing the same outputs, but an individual firm does not know whether the other firms and industries will be affected the same way in a shock. Cutting prices in a situation would not necessarily create more demand for a firm's products; it may just lead to lower profits and bankruptcy. [1] :381 Firms face large information requirements in determining how to optimize their pricing. They not only have to know the demand for their own goods and their own costs, they have to know the pricing factors for all their competitors and other firms in the vast market of inputs and outputs. [1] :382 Capital market imperfections lead to more real rigidities. Capital markets may have asymmetric information problems because borrowers are better aware of their situation than lenders. This can lead to firms seeking more external finance during downturns, which drives up the firm's cost and creates another rigidity. [1] :382 Imperfect information can also create rigidity in the consumer market. Consumers may see price as an indicator for quality. Firms may be reluctant to cut their prices if they fear that consumers might start to the product as "cheap". [1] :382

Supply chain system of organizations, people, activities, information, and resources involved in moving a product or service from the point where it is manufactured to where it is consumed

In business and finance, supply chain is a system of organizations, people, activities, information, and resources involved in moving a product or service from supplier to customer. Supply chain activities involve the transformation of natural resources, raw materials, and components into a finished product that is delivered to the end customer. In sophisticated supply chain systems, used products may re-enter the supply chain at any point where residual value is recyclable. Supply chains link value chains.

In the labor market

New Keynesian economists have sought to explain persistently high unemployment in industrialized economies. New Keynesians explain part of this excess supply in the labor market with real wage rigidities that hold wages above market clearing levels. [1] :383 Economists have three main groups of theories for explaining real rigidities in the labor market: implicit contract theories, efficiency wage theories, and insider-outsider theories. New Keynesian economics is especially associated with the latter two. [1] :383 Implicit contract theory attributes stable real wages to implied agreements between employers and workers. Firms serve not just as consumers of labor, but also as wage insurers. By showing their workers that they will provide stable real wages, firms secure their loyalty. [1] :384 Seeing implicit contracts as a poor basis for real wage rigidities, new Keynesian economists sought other explanations. [1] :384

In economics, implicit contracts refer to voluntary and self-enforcing long term agreements made between two parties regarding the future exchange of goods or services. Implicit contracts theory was first developed to explain why there are quantity adjustments (layoffs) instead of price adjustments in the labor market during recessions.

The insider-outsider theory is a theory of labor economics that explains how firm behavior, national welfare, and wage negotiations are affected by a group in a more privileged position. The theory was developed by Assar Lindbeck and Dennis Snower in a series of publications beginning in 1984.

Efficiency wage theories explain why firms might pay their employees more than the market clearing rate. Since workers' productivity can be dependent on their wages, employers have an incentive to pay their workers to the point where they are most productive. Under these models, wages are not determined strictly by the supply and demand for labor but by the marginal productivity of workers. [2] :357 Economists have several explanations for the intuition behind efficiency wages. In "adverse selection" models, firms find it more cost effective to offer a high wage and attract skilled workers rather than carefully investigating a workers skills and firing workers who turn out not to be adequately skilled. [1] :388 In the "shirking model," a firm pays a worker above the market rate because they want to give the worker an incentive to perform well and not shirk at his current job. If the worker's next best job opportunity offers lower pay than his current position, he will have an incentive to perform well to keep his current job. [2] :357 In "turnover cost" models, firms pay their workers above market wages to prevent turnover and the costs of recruiting and training replacement employees. [2] :357 In "gift exchange" models firms pay high wages to increase productivity through improved worker morale. [2] :358 In fairness models, a more recent trend in the efficiency wage literature, employers have to pay a sociologically "fair" wage in order to encourage workers to be productive. [1] :391

Adverse selection is a term commonly used in economics, insurance, and risk management that describes a situation where market participation is affected by asymmetric information. When buyers and sellers have different information, it is known as a state of asymmetric information. Traders with better private information about the quality of a product will selectively participate in trades which benefit them the most, at the expense of the other trader. A textbook example is Akerlof's market for lemons.

Related Research Articles

Microeconomics is a branch of economics that studies the behaviour of individuals and firms in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms.

In economics, specifically general equilibrium theory, a perfect market is defined by several idealizing conditions, collectively called perfect competition. In theoretical models where conditions of perfect competition hold, it has been theoretically demonstrated that a market will reach an equilibrium in which the quantity supplied for every product or service, including labor, equals the quantity demanded at the current price. This equilibrium would be a Pareto optimum.

Inflation increase in the general price level of goods and services in an economy over a period of time

In economics, inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy. The measure of inflation is the inflation rate, the annualized percentage change in a general price index, usually the consumer price index, over time. The opposite of inflation is deflation.

This aims to be a complete article list of economics topics:

The Phillips curve is a single-equation econometric model, named after William Phillips, describing a historical inverse relationship between rates of unemployment and corresponding rates of rises in wages that result within an economy. Stated simply, decreased unemployment, in an economy will correlate with higher rates of wage rises. Phillips did not himself state there was any relationship between employment and inflation; this notion was a trivial deduction from his statistical findings. Samuelson and Solow made the connection explicit and subsequently Milton Friedman and Edmund Phelps put the theoretical structure in place. In so doing, Friedman was to successfully predict the imminent collapse of Phillips' a-theoretic correlation.

In economics, economic equilibrium is a situation in which economic forces such as supply and demand are balanced and in the absence of external influences the (equilibrium) values of economic variables will not change. For example, in the standard textbook model of perfect competition, equilibrium occurs at the point at which quantity demanded and quantity supplied are equal. Market equilibrium in this case is a condition where a market price is established through competition such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by sellers. This price is often called the competitive price or market clearing price and will tend not to change unless demand or supply changes, and the quantity is called the "competitive quantity" or market clearing quantity. However, the concept of equilibrium in economics also applies to imperfectly competitive markets, where it takes the form of a Nash equilibrium.

Principal–agent problem Agency Problem

The principal–agent problem, in political science and economics occurs when one person or entity, is able to make decisions and/or take actions on behalf of, or that impact, another person or entity: the "principal". This dilemma exists in circumstances where agents are motivated to act in their own best interests, which are contrary to those of their principals, and is an example of moral hazard.

In labor economics, the efficiency wage hypothesis argues that wages, at least in some markets, form in a way that is not market-clearing. Specifically, it points to the incentive for managers to pay their employees more than the market-clearing wage in order to increase their productivity or efficiency, or reduce costs associated with turnover, in industries where the costs of replacing labor are high. This increased labor productivity and/or decreased costs pay for the higher wages.

In economics, a menu cost is the cost to a firm resulting from changing its prices. The name stems from the cost of restaurants literally printing new menus, but economists use it to refer to the costs of changing nominal prices in general. In this broader definition, menu costs might include updating computer systems, re-tagging items, and hiring consultants to develop new pricing strategies as well as the literal costs of printing menus. More generally, the menu cost can be thought of as resulting from costs of information, decision and implementation resulting in bounded rationality. Because of this expense, firms sometimes do not always change their prices with every change in supply and demand, leading to nominal rigidity. Generally, the effect on the firm of small shifts in price is relatively minor compared to the costs of notifying the public of this new information. Therefore, the firm would rather exist in slight disequilibrium than incur the menu costs.

Dynamic stochastic general equilibrium modeling is a method in macroeconomics that attempts to explain economic phenomena, such as economic growth and business cycles, and the effects of economic policy, through econometric models based on applied general equilibrium theory and microeconomic principles.

New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical framework. Specifically, it emphasizes the importance of rigorous foundations based on microeconomics, especially rational expectations.

AD–AS model

The AD–AS or aggregate demand–aggregate supply model is a macroeconomic model that explains price level and output through the relationship of aggregate demand and aggregate supply.

Involuntary unemployment occurs when a person is willing to work at the prevailing wage yet is unemployed. Involuntary unemployment is distinguished from voluntary unemployment, where workers choose not to work because their reservation wage is higher than the prevailing wage. In an economy with involuntary unemployment there is a surplus of labor at the current real wage. This occurs when there is some force that prevents the real wage rate from decreasing to the real wage rate that would equilibrate supply and demand. Structural unemployment is also involuntary.

The Rehn–Meidner model is an economic and wage policy model developed in 1951 by two economists at the research department of the Swedish Trade Union Confederation (LO), Gösta Rehn and Rudolf Meidner. The four main goals to be achieved were:

History of macroeconomic thought

Macroeconomic theory has its origins in the study of business cycles and monetary theory. In general, early theorists believed monetary factors could not affect real factors such as real output. John Maynard Keynes attacked some of these "classical" theories and produced a general theory that described the whole economy in terms of aggregates rather than individual, microeconomic parts. Attempting to explain unemployment and recessions, he noticed the tendency for people and businesses to hoard cash and avoid investment during a recession. He argued that this invalidated the assumptions of classical economists who thought that markets always clear, leaving no surplus of goods and no willing labor left idle.

Jacques H. Drèze is a Belgian economist noted for his contributions to economic theory, econometrics, and economic policy as well as for his leadership in the economics profession. Drèze was the first President of the European Economic Association in 1986 and was the President of the Econometric Society in 1970.

References

  1. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 Snowdon, Brian; Howard Vane (2005). Modern Macroeconomics. Cheltenham: E. Elgar. ISBN   978-1-84542-208-0.
  2. 1 2 3 4 Froyen, Richard (1990). Macroeconomics, Theories and Policies. New York: Macmillan. ISBN   978-0-02-339482-9.

Further reading

David Hibbard Romer is an American economist, the Herman Royer Professor of Political Economy at the University of California, Berkeley, the author of a standard textbook in graduate macroeconomics as well as many influential economic papers, particularly in the area of New Keynesian economics. He is also the husband and close collaborator of Council of Economic Advisers former Chairwoman Christina Romer.

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