Econ 488: The Advanced Macro Adventure!

Traditional classical thought assumed that price and wage flexibility were such that the economy always managed to move toward the market clearing level. This assumption was questioned by Keynes who argued that firms adjusted quantities because of price and wage stickiness, which decreased the likelihood of full employment. In reality, the traditional classical thought applied to larger items, such as homes and things that could be auctioned off, where price adjustment was a feasible option. The Keynesian way of looking at things applied more to smaller items, where a fixed price was a more pragmatic approach. New Classical economic thought provided a theoretical explanation for why this dichotomy exists.

New Classical thought introduces the profit maximization behavior of firms into their macro model. They assert that an equilibrium will not be achieved without information. In order for markets to clear, there must be perfect information which is only attainable by specialized traders with relatively clear rational expectations. Realistically, these assumptions can only refer to homogeneous products. (Heterogeneous products are a little trickier, and therefore more interesting.)

The price for information on expectations in the heterogeneous product market is greater than its homogeneous counterpart, and therefore specialized traders have no place in this marketplace. Therefore prices are more likely to be fixed. Heterogeneous products refer to anything where there is variation among specific choices of the same thing. Think of going to the grocery store and picking out fruit: you don’t want to just send a person to pick up a piece of fruit at random, because there’s a chance that it will be of a lower quality than what you expect. Choosing your piece of fruit requires deliberation, and therefore you need to cut out the middleman and set standard prices so the quality of the fruit isn’t up for debate. The labor market is the same way - an employer will want to assess the quality of a worker because of the abundance of variables involved in the labor market, and therefore is not likely to delegate the task to an arbitrary specialized labor trader (at least not in countries that respect human rights, more or less).

Price fixing allows firms to make a good available at a variety of locations with minimal transactions costs, and also avoids adjustment costs that he would need to accrue if he were interested in adjusting his prices to be market clearing. Therefore, price setters establish their prices to match their expected long run economic trends. This requires less coordination since the final price is created with enough leeway to account for short run price variation. Firms’ efforts to maximize their profits relative to competing firms also will inhibit them from adjusting their prices, as no firm wants to be the first to lower prices and thereby lose profits for the sake of being in equilibrium. They are more likely to adjust their quantities to account for a decrease in aggregate prices.

I don’t remember what it was about exactly, but the term “fixpricety” was somewhere in this chapter.

Shaw, G.K. 1984. Rational Expectations and Price Flexibility. in Rational Expectations: An Elementary Exposition, 73-82. New York, NY: St. Martin’s Press.

It’s half past one in the morning. This blog post requires a disclaimer. Since those weaken arguments, I’m not putting one on here - just imagine that I included a really killer one that COMPLETELY makes up for any inconsistencies or grammatical errors.