Saturday, June 30, 2012

Price Rigidity in New Keynesianism and Post Keynesianism

An empirical observation of real world economies is that the prices of a considerable number of goods respond slowly or incompletely to changes in demand. According to empirical studies in the Western economies, firms only rarely change their prices, perhaps on average once a year (Melmiès 2010: 450).

The genesis of New Keynesian economics was in fact an attempt to establish empirical support for price stickiness, even though the New Classicals argued that the existence of price stickiness allegedly lacked microeconomic foundations in view of their rational expectations theory (Melmiès 2012: 452).

The New Keynesians proposed various explanations of real world price stickiness, including the following factors:
(1) Menu costs
(2) Implicit contracts
(3) Nominal contracts
(4) Coordination failure
(5) Cost-based pricing
(6) Constant marginal cost
(7) Non-price competition
(8) Pricing threshold
(9) Link between quality and price. (Melmiès 2012: 453).
More empirical work established that businesses themselves viewed the implicit contract, nominal contract, coordination failure, and cost-based pricing factors as the most important in affecting price rigidity (Melmiès 2012: 453; Blinder 1998). Most notably, the New Keynesian menu costs, nonprice competition, and costly information ideas did not receive much support (Melmiès 2010: 453).

Furthermore, the New Keynesian idea is fundamentally one of constrained price stickiness: firms wish to change their prices, but are constrained by factors from doing so (Melmiès 2012: 454).

By contrast, Post Keynesians would say that many firms quite deliberately set prices. Firms act to ensure their survival and grow their business and market share. By looking more at the long term state of demand, the price of many products is often not affected by short term changes in demand. The most important cause of price adjustments are changes in the costs of factor inputs and wages. Thus the pricing policies of firms are quite conscious and deliberate acts of price administration and setting, and this action results in a deliberately-caused price stickiness in the market. A consequence of this is that profit margins are also stable, and such margins are needed for internal financing of investment.

It is important to distinguish between the New Keynesian view of price rigidity and that of Post Keynesianism.

New Keynesians believe that, if only prices were perfectly flexible, then economies would adjust rapidly to full employment equilibrium. Post Keynesians, following Keynes himself, reject the view that perfectly flexible wages, prices and perfect competition would lead to full employment equilibrium. Even if there were perfectly flexible wages and prices, there could still be failures of aggregate demand (Davidson 1992).

In Post Keynesianism, therefore, price rigidity is not the fundamental cause of demand affecting output (Melmiès 2012: 456).


Blinder, A. S. et al. (eds.). 1998. Asking About Prices: A New Approach to Understanding Price Stickiness, Russell Sage Foundation, New York.

Davidson, P. 1992. “Would Keynes be a New Keynesian?,” Eastern Economic Journal 18.4: 449–463.

Melmiès, J. 2010. “New-Keynesians Versus Post-Keynesians on the Theory of Prices,” Journal of Post Keynesian Economics 32.3: 445-466.

Melmiès, J. 2012. “Price Rigidity,” in J. E. King, The Elgar Companion to Post Keynesian Economics (2nd edn.). Edward Elgar, Cheltenham. 452–456.


  1. I would think that transaction cost provides a simple explanation for why firms set prices and use layoffs or cut hours instead of making wage adjustments.

    In "The Nature of the Firm" (1937), Coase observed that there are costs involved in using the price mechanism. Many firms have probably figured out that it is more cost-effective not to adopt purely market solutions but to set prices — which is likely why we now have the modern firm instead of bazaar stalls and traditional haggling in goods markets. Only assets markets are actually "markets" in the sense of value being determined by changes in the marginal price.

    Greater standardization accommodated this, and it is also why we are headed toward automation and robotics. Technology is a lot more tractable than human resources.

  2. Anybody who believes the NK line really ought to spend some time operationally running a smaller business (large enough to be more than a one man band, but still small enough so one person can overview all the functions).

    Then you will see on the ground that the PK description is correct. Most businesses are cost plus operations and spend 99% of their time fretting about their sales pipeline.

    1. "Most businesses are cost plus operations and spend 99% of their time fretting about their sales pipeline."


  3. LK:

    Regarding price adjustments, here's another study that finds evidence that firms will adjust quantity before price:

    Price and Quantity Adjustment over the Business Cycle: Evidence from Survey Data
    Author(s): V. Bhaskar, Stephen Machin, Gavin C. Reid. Oxford Economic Papers, New Series, Vol. 45, No. 2 (Apr., 1993), pp. 257-268

    The works it cites in turn may also be of value.

  4. "Post Keynesians, following Keynes himself, reject the view that perfectly flexible wages, prices and perfect competition would lead to full employment equilibrium. Even if there were perfectly flexible wages and prices, there could still be failures of aggregate demand (Davidson 1992)."

    Because of subjective expectations? Whats the mechnism involved then? Unstable deflation expectations? Because expectations theories are not unique to Post Keynsians New Keynsians or even New Classicals. Theoretically, what if the CB or government wanted deflation to roll back years of previous inflation, say 20%. It would then promise that once that price level has been reached, it would relax monetary policy again. Wouldn't this of an NGDP growth level target solve uncertain subjective expectations?

    1. It is not just because the aggregate level of investment is unstable owing to subjective expectations, but also because Say's law, in all its forms, is a myth

  5. "Wouldn't this OR an NGDP growth level target solve uncertain subjective expectations"

    1. As I said, the problem is also that Say's law is invalid.

      As Frank H. Hahn argued, “It is therefore not money which is required to do away with a Say’s Law-like proposition that the supply of labour is the demand for goods produced by labour. Any non-reproducible asset will do. When Say’s law is correctly formulated for an economy with non-reproducible goods it does not yield the conclusions to be found in textbooks. As I have already noted Keynes was fully aware of this and that is why he devoted so much space to the theory of choice amongst alternative stores of value” (Hahn, F. H. 1977. “Keynesian Economics and General Equilibrium Theory: Reflections on Some Current Debates,” in G. C. Harcourt (ed.), The Microeconomic Foundations of Macroeconomics, Macmillan, London. p. 31).

      Secondary financial asset markets (and even secondary real asset markets) divert income from purchasing of final goods and services, leading to leakages in the value of total annual aggregate supply.

      That is why annual net new flows of private debt are fundamental to capitalist economies.

      Once the instability of investment is thrown in, with the dynamics of debt deflation, it is clear that market economies do not necessarily converge to full employment equilibrium.