Price Flexibility - Essay Example

Closed Economy: In a closed economy characterized by the presence of fully wage and price flexibility the equilibrium is supply determined. The factor market determines the aggregate supply of an economy. If we consider the labour as the only variable factor of production for the sake of simplicity the labor market equilibrium determines the equilibrium level of employment and by using the classical production function and the equilibrium level of employment we can find the equilibrium level of supply. Let us consider the labour market equilibrium. We assume the presence of perfect competition in both product and labour markets. The demand function of labour is obtained by the profit maximizing behaviour of a rational firm. The profit function of a perfectly competitive firm can be given as, Π = P.f(L) – W.L. --- While Π= profit, P= price, f(L)= production function, L= employment of labour and W= money wage. The necessary condition of profit maximization implies: dΠ/dL = 0  P.f/(L) – W = 0 The second order condition is: d2 Π/ dL2 < 0  Pf2 (L) < 0 (Sufficient condition) Or, from the necessary condition we can write W = P. f/ (L) while f/(L) = MPL  P. MPL = Value of marginal productivity of labour (VMPL) (See: Stilwell, Lipsey and Clark 1970) According to the profit maximizing behaviour of the firm the value of marginal productivity of labour should be equal to the money wage. Or in other words we can say, W/P = MPL i.e. the real wage should be equal to the marginal productivity of labour. Actually the labour demand function is dependent on the real wage. Lower the real wage lower would be the average cost of production and given the price higher would be the level of profit. (Ferguson and Gould, 1980) The labor demand curve is nothing but the downward sloping MPL curve. From the sufficient condition we can write, F2 (L) < 0  dMPL /dL < 0 I.e. the marginal productivity curve of labour is downward sloping. The demand curve for labour can be shown with the help of following diagram. In the following diagram the horizontal and vertical axes measure real wage (W/P) and employment of labour respectively. MPL is the marginal productivity curve of labor which shows the one to one correspondence between real wage and labour demand respectively. (Gravelle and Rees 1981) w= Figure 1 MPL 0 L By the lateral summation of the demand curves of individual firms we can obtain the market demand curve of labour. Now the individual labour supply function is obtained from the individual utility maximizing behaviour. The lateral summation of the individual supply curve gives the aggregate labour supply curve. According to the classics the labour supply is a function of real wage. The labour force is concerned about the real wage and higher real wage implies the higher supply of labour. (Robinson and Eatwell 1974) Hence the labour supply curve is positively sloped. We can show the supply function with the following diagram. W (Fig from: LS 0 L The horizontal and vertical axes measure amount of labour and real wage respectively, the positively sloped labour supply curve represents the one to one correspondence between real wage and supply of labour. The equilibrium level of employment and real wage rate are determined by the intersection of the labour demand and supply curves. The equilibrium level of supply is determined by the interaction of labour demand and supply functions and the production function. According to the classics the flexibility of wage and price maintains the full employment of labour in the labour market and any dispersion from the equilibrium would be automatically adjusted through the flexibility of wage and price. The labour market equilibrium and the aggregate supply function of the economy are obtained by the following set of diagrams. w   w* A B   Yf Y Y F(L) L P (Froyen, 2003, 57) In figure 2a the horizontal and vertical axes measure the labour and real wage respectively. The equilibrium level of labour employment and real wage are determined by the intersection of labour demand and supply curves (Lf and w1 respectively). In figure 2b the horizontal and vertical axes measure labour employment and level of output respectively. The f (L) curve represents the production function and plotting the L in the production function we obtain the full employment level of supply Yf that is not dependent on price. In figure 2c the horizontal and vertical axes measure price and aggregate supply respectively. Yf is a straight-line, which is parallel to the horizontal axis, is the aggregate supply curve. It implies the flexibility in wage rate and price maintains the equilibrium. (Froyen 2003) Now what will be the role of aggregate demand in the economy? Actually, in a supply dominated system the aggregate demand determines the price level, which can be shown by the help of the following diagram. P Yf D* D P* P O Y (Mankiw, 2003: pp65) In the above figure (fig 3) the horizontal and vertical axes measure output and price respectively. The vertical straight-line represents the supply curve demonstrating the fact that the factor market determines aggregate supply. D is the initial demand curve. The OP is the equilibrium level of price. Now if there is a rise in the aggregate demand of the economy then what will happen? The answer is very easy. The supply cannot be increased as the economy is in a full employment level of output. Hence the excess demand situation would pull up the price level to OP*. That price inflation would also be followed by wage inflation i.e. the workers would charge a proportionate rise in the money wage to maintain the desired real wage. (Mankiw 63-65) Now we consider three cases: a) An increase in desire to consume: While the consumers have a higher desire to consume that would definitely boost up the consumption demand in the economy, hence the economy would face a rise in aggregate demand. However, as the economy is at the full employment situation there is no chance to adjust the supply according to the demand. Consequently, the price would start to rise and hence the real balance of the consumers starts to decline. This process is continued unless the purchasing power of the consumer make the consumers reach there previous level of consumption demand. The output level would remain unchanged and the nominal interest rate would change due to higher demand for money but the expected rate of inflation also rises equally hence the real rate of interest would be unchanged. (Wykstra 1971) b): A reduction in the supply of money: While the economy faces a reduction in the supply of money the money market faces excess demand situation, which is followed by a rise in the rate of interest of the economy. Certainly that rise in the rate of interest causes a decline in the level of private investment. Equally a decline in real balance in the hand of the people causes a decline in consumption demand. Hence there is a decline in aggregate demand. That is represented by a leftward shift of the aggregate demand curve. However, the supply side remains undisturbed and hence there is no impact on the level of employment and output of the economy. There is a decline in price and an increase in the rate of interest. The money wage is also adjusted to maintain the equilibrium in the factor market. (Simpson, 1979) c): The Government Imposes Minimum Wage Law: While the government imposes minimum money wage law the labour market equilibrium is disturbed. The flexibility of wage and price that acts as a stabilizing agent is disturbed by the government act. That may cause a problem of unemployment and decline in the level of aggregate output. For example, if we consider figure 2a. Let us consider that by the law the government imposes a floor on the real wage. Let it be w*. The wage price flexibility cannot work now. At w* there exists excess supply of labour. Hence the output will fall below the full employment level of output. Given the price level there would emerge an excess demand situation and consequently the price would rise. This is the case of cost-push inflation; to be clearer we can say an inflationary situation coupled with unemployment, which can be termed as stagflation. Due to the rise in the price level there would be a rise in demand for money and consequently the rate of interest would rise. (Stonier and Hague, 1964 ) Hence from the above analysis it is clear that in a situation characterized by perfect wage and price flexibility the factors that affect demand side cannot influence the level of aggregate supply or employment. They can only change monetary wage and price level and rate of interest. But the factors that affect supply side can change the real as well as the monetary variables. References 1. Mankiw, N.G 2003 Macroeconomics: Fifth Edition Worth Publishers: pp: 63-65 2. Froyen R.T., 1999. Macroeconomics: Theories and policies. 6th ed. Singapore: Addison Wesley Longman. Pp: 53- 57 3. Gravelle, H. And Rees, R. 1981, Microeconomics; Longman Group UK Limited p:369 4. Robinson, J. And Eatwell J. 1971. An Introduction to Modern Economics: pp: 130-131 5. Simpson, D. 1975, General Equilibrium Analysis: Basil Blackwell Oxford, Page 67-69 6. Stilwell, J. A. Lipsey, R. G and Clarke R. 1970 “Workbook to Accompany the Fifth Edition of An Introduction to Positive Economics”. English Language Book Society. Ch 12 7. Stonier A.W and Hague, D. C. 1964. A Textbook of Economic Theory: English Language Book Society: London pp:651-653 8. Wykstra, R. A 1971. Introductory Economics By: Harper and Row, pp: 224-225 Read More