Price setting problem: Rigidities

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1 Advanced Monetary Theory and Policy EPOS 2012/13 Price setting problem: Rigidities Giovanni Di Bartolomeo

2 New Keynesian Economics Most economists believe that short-run fluctuations in output and employment represent deviations from the natural rate, and that these deviations occur because wages and prices are sticky. New Keynesian research attempts to explain the stickiness of wages and prices by examining the microeconomics of price adjustment.

3 Recessions as coordination failure In recessions, output is low, workers are unemployed, and factories sit idle. If all firms and workers would reduce their prices, then economy would return to full employment. But, no individual firm or worker would be willing to cut his price without knowing that others will cut their prices. Hence, prices remain high and the recession continues.

4 The staggering of wages and prices All wages and prices do not adjust at the same time. This staggering of wage & price adjustment causes the overall price level to move slowly in response to demand changes. Each firm and worker knows that when it reduces its nominal price, its relative price will be low for a time. This makes them reluctant to reduce their price.

5 Top reasons for sticky prices 1. Coordination failure: firms hold back on price changes, waiting for others to go first 2. Firms delay raising prices until costs rise 3. Firms prefer to vary other product attributes, such as quality, service, or delivery lags 4. Implicit contracts: firms tacitly agree to stabilize prices, perhaps out of fairness to customers 5. Explicit contracts that fix nominal prices 6. Menu costs Results from surveys of managers

6 Monopolistic competition Perfect competition: market forces prices to adjust rapidly (sellers are price takers). Instead, if sellers have some degree of monopoly, they are price setters (e.g. monopolistic competition) and they set prices in nominal terms and maintain those prices for some period adjust output to meet the demand at their fixed nominal price readjust prices from time to time when costs of demand change significantly Keynesians suggest that markets are characterized by monopolistic competition.

7 Monopolistic completion: main features Many sellers Product differentiation Free entry and exit

8 Many sellers There are many firms competing for the same group of customers. This feature of monopolistic competition is shared with perfect competition, which we studied in an earlier chapter So, the decisions made by one firm do not affect other firms in any perceptible way

9 Product differentiation Similar but non-identical products Each firm produces a product that is at least slightly different from those of other firms. As a result, Rather than being a price taker, each firm faces a downward-sloping demand curve. Price Demand Quantity Monopolistic competition shares this feature with monopoly.

10 Free entry or exit Firms can enter or exit the market without any difficulty. As a result, The number of firms in the market adjusts until economic profits are zero. This is another feature of monopolistic competition that it shares with perfect competition

11 How does it work? Apart from the fact that the demand curve for the monopolistic competitor s product is technically flatter than the demand curve for the monopolist s product, the graphs look essentially the same (elasticity) perf comp mon com monopoly P P P D D D Q Q Q

12 Recap: Monopoly Price MC ATC Price Average total cost Profit MR Demand 0 Profitmaximizing quantity Quantity

13 A Rule of thumb for pricing We want to translate the condition that marginal revenue should equal marginal cost into a rule of thumb that can be more easily applied in practice Looking at Marginal Revenue MR R ( PQ) P Q Q P Q Q Q P Q P P Q P P Q P Q

14 A rule of thumb for pricing By considering the demand elasticity d P Q Q P We can write ( PQ) Q P 1 MR P P P P Q P Q d

15 A rule of thumb for pricing Profit maximization needs It follows MR = MC P P 1 MC P P MC P D 1 D MC D MC D D

16 A rule of thumb for pricing: Example Consider Assume Then P D MC 1 1 D 6 MC 9 P

17 Monopolistic competition in the short run Price Price (a) Firm Makes Profit MC ATC These profits will not last. Short-run economic profits encourage new firms to enter the market. This reduces the demand faced by firms already in the market (incumbent firms) Average total cost Profit Demand Incumbent firms demand curves shift to the left. Their profits fall MR 0 Profitmaximizing quantity Quantity

18 Entry of new firms on an incumbent Price (a2) Firm Makes Less Profit MC ATC These profits will not last either. Profits encourage new firms to enter the market. This reduces the demand faced by incumbent firms Price ATC Profit MR Demand Incumbent firms demand curves shift to the left. Their profits fall 0 Profitmaximizing quantity Quantity

19 Monopolistic competition in the long run (a3) Firm Makes No Profit Price MC ATC Price = ATC Zero profit Demand MR 0 Profitmaximizing quantity Quantity

20 Short run losses Price Average total cost Price Losses (b) Firm Makes Losses MC ATC These losses will not last. Losses force some incumbent firms to exit the market. This will increase the demand faced by the remaining firms Their demand curves will shift to the right. Their losses will shrink In the long run, profits will be zero! MR Demand 0 Lossminimizing quantity Quantity

21 Long run no losses Price MC ATC We have seen that in the long run profits cannot be positive or negative. Therefore, profits must be zero! Note that P = ATC > MR = MC in long run equilibrium. P = ATC MR = MC MR Demand 0 Profit-maximizing quantity Quantity

22 Monopolistic vs. perfect competition All firms maximize profits This means MR = MC So, MR = MC is true under both monopolistic and perfect competition Monopolistic competition is like monopoly in the sense that firms face downward-sloping demand curves Downward-sloping demand curves imply P > MR Monopolistic is like perfect competition: in the sense that there is free entry in the long run This means P = ATC So, simply by looking at the features of monopoly and perfect competition that are combined in monopolistic competition, we can see that P = ATC > MR = MC

23 Monopolistic vs. perfect competition Two main differences: excess capacity; price markup over marginal cost. Perfect Competition Excess Capacity No: equilibrium quantity = efficient output. Monopolistic Competition Yes: equilibrium quantity < efficient output Price Markup No: P = MC Yes: P > MC

24 Monopolistic vs. perfect competition (a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm Price Price MC ATC MC ATC Markup P Marginal cost MR Demand P = MC P = MR (demand curve) 0 Quantity produced Efficient scale Quantity 0 Quantity produced = Efficient scale Quantity Excess capacity P = ATC > MR = MC The long run equilibrium under monopolistic competition shows both excess capacity and a price markup over marginal cost. Under perfect competition, there s neither. P = ATC = MR = MC The basic reason for this difference in outcome lies in the difference in the slope of the firm s demand, which is negatively sloped in monopolistic competition and horizontal under perfect 24 competition.

25 Welfare Monopolistic competition does not have all the desirable properties of perfect competition. 25

26 Welfare Price MC P = ATC Long run equilibrium ATC Note that at the optimum outcome P = MC < ATC. MR Optimum Demand So, the optimum can be enforced by a government regulator only through subsidies. 0 Profit-maximizing quantity Quantity 26

27 GE Model (Blanchard and Kiyotaki, 1987) Non stochastic static general equilibrium model Assumptions Flexible prices and wages Monopolistic competition in good market Perfect competition in labor market Results Pareto inefficient (coordination failure) Prisoner dilemma no incentive to cut the prices But money neutrality Voluntary unemployment

28 Blanchard and Kiyotaki (1987) Flexible prices and monopolistic competition: money neutrality (monopolistic competition is not enough) P Y CM Y CP Natural output Efficient output AD ( M ' > M) AD Y