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Price Stickiness
Another fact that the New Keynesians set out to explain was price stickiness, that is,
Prices in the real world appear not to be as flexible as the Classical economists assume.
Recall that price stickiness is an immense feature of the Keynesian model since if prices
are sticky, then both monetary and fiscal policy will have real effects, that is, the LM
curve will not immediately return the economy back to full employment (recall money
neutrality relies on perfectly flexible prices). This being the case, the Keynesian’s argue
that both monetary and fiscal policy can this exploit this price rigidity and steer the cruise
ship into port. If fact, the Keynesians go one step farther and argue that it is the
obligation or duty of policymakers to pursue full employment and stable prices, many
times referred to as a dual mandate. Click Here for more.
So why are prices sticky? The first observation is that we need to note that it is costly to
change prices and thus, we reason that if the marginal cost of changing prices is greater
than the marginal benefits of changing prices, then the firm will keep prices constant.
The cost of changing prices is referred to as menu costs, referring to the costs of revising
and reprinting a menu from a restaurant. Menu costs can explain a bit of price stickiness,
but there is more to the story.
Imperfect competition. Implicitly assumed in the Classical model was that all firms fell
into the perfectly competitive framework so that firms were price takers. The idea is that
when demand or supply conditions changes, there will be an immediate change in the
price reflecting these changes. Recall that in a world of perfect competition, firms face a
horizontal demand = marginal revenue curve. In other words, the firm can sell as much
as they want at the given price, they won’t charge a lower price because that would be
irrational and they won’t charge a higher price because if they did, they would sell
nothing. Of course, only a small sector of the economy can be characterized as perfectly
competitive, the rest is referred to as imperfect competition. Most would agree that
monopolistic competition is the most prominent form of competition in the US economy
and thus, firms do possess some market power implying that their individual demand
curves are downward sloping and thus, they are price setters as opposed to price takers.
Markup Pricing. As you learned in your principles of microeconomics class, the profit
maximizing condition in the product markets is to set marginal revenue equal to marginal
cost. With a downward sloping demand curve, this profiting maximizing output occurs
when the price of your product exceeds the marginal cost of production. We can
characterize this reality by setting the price at a markup over marginal costs.
6) P* = (1 + η)MC
Use the space below to show that the price is always above marginal cost in a
monopolistically competitive market.
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With prices set above marginal costs, the firm acts like a vending machine. That is,
suppose that demand increases. Does the firm immediately raise prices? According to
Classical economics, prices would rise immediately. But let us consider the costs of
raising prices. We have already mentioned the menu costs and of course they are very
relevant. But there are other issues. For one, is the shock to demand permanent or
temporary? If it is temporary, then it would be best not to change prices and just meet the
increase in demand at the same price (i.e., fill up the vending machine more often). If the
shock is permanent, then it would be best to raise prices but since it is difficult to identify
the temporary vs. permanent nature of shocks, it is rational for the firm to wait, and try to
obtain more information before making a pricing decision. Beyond this reality, the firm
has to be very aware of market share as in, what are my competitors doing? For example,
supposed you own a movie theater and you are contemplating raising prices. If all the
other movie theaters in town do not raise their prices, then you may very well lose some
market share (and customer loyalty). It might be best for you to meet the additional
demand at the same price as long as the price is above the marginal cost of production.
This being the case, profits will still rise, even though you may not be maximizing them
in the short run. In the long run, given the shock is permanent, prices will adjust, but this
entire process will take a while, consistent with the empirical observation that prices are
sticky.
Effective Demand for Labor – the final component of Keynesian economics revolves
around the effective demand for labor. This concept is very simple yet very powerful.
The idea is that the demand for labor is determined by the demand for output. If output
falls as it does in a recession, then the amount of labor needed to produce the lower
output is less and therefore, workers will be laid off. The solution of course is to
stimulate aggregate demand via expansionary fiscal and monetary policy and as you do,
you will create jobs, since more workers are needed to satisfy the increased appetite
(higher aggregate demand). The effective demand curve for labor is drawn similar to the
production function, except we reverse the axes. Use the space below to draw the
effective demand for labor.
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Keynesian Thoughts on Fiscal vs. Monetary Policy. Keynes much preferred Fiscal policy
because he felt it was more reliable. He believe that monetary policy was unreliable
since the main channel in which monetary policy works is through investment and
durable good consumption.
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