Question

Discuss the various types of frictions and distortions in labor and product markets that make the adjustments of wages and prices slow, according to New Keynesian macroeconomists.

Answer 1

Ans The new Keynsian macroeconomists put forward basically two arguments in favour of wage and price rigidity in labor and product markets respectively. The slow adjustment of wages in the labor market is explained by the efficiency wage hypothesis, which states that wages are set not to clear market. The incentive of the entrepreneurs is to pay their employees more than the the market clearing wage in order to increase their productivity or efficiency, or avoid the high costs associated with replacing labors. There are several theories of why managers pay efficiency wages-

firstly, to avoid shirking. The manager pays an efficiency wage in order to create or increase the cost of job loss, i.e. if the laborers shirk in their work the manager may fire them.

secondly, to minimize the cost of replacing current laborers. By paying efficiency wage the managers try to incentivize the laborers not to leave the job and look for alternatives because cost of replacing these laborers maybe high which icludes advertisement for job, recruitment cost, training cost etc.

Thirdly, In developing countries, efficiency wages allow the laborers to eat nutritional food which help them to improve their productivty.

The slow adjustment of prices in the product market is explained by the menu cost hypothesis. The prices donot adjust immediately to clear markets is because adjusting prices is costly. This is explained with the help of a simple restaurent example. Suppose a firm is considering to change its menu. however changing the menu requires some cost which will have to be added to the price of the items and also printing the new menu can be profitable for the restaurent. Now, before changing the menu the restaurent will consider both the cost of changing the menu and the resultant profit to be obtained from increase in the price. If the cost is higer than the profit, the restaurent choose not to change the price.