Notes on Keynesian Economics

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Notes on Keynesian Economics
As we know, Keynesian economics is different from Classical economics in that Keynesian economics promotes a hands on policy prescription. According to our cruise ship analogy, Keynesian economics implies that we can steer the ship where Classical economics suggest the ship is going to go where it is going to go, and trying to steer it will only make us worse off.
The foundation for Keynesian economics lies in sticky wages and prices. In Keynes’ original work, he did not explain why nominal wages and prices were sticky, he just took it as a given. In the 1970s, the classical economists challenged the Keynesian economists to explain why wages and prices were sticky. The argument was that firms and workers are the ones involved in these decisions and to take sticky wages and prices as given was not acceptable, they had to explain, using rational economic decision making, why wages and prices were sticky.
The New Keynesians were thus born. The New Keynesians began by arguing that wages, at least nominal wages, could be sticky due to unions and minimum wage legislation. This argument is sound but since so few people (as a percent of the labor force) in the US economy are in unions or earning minimum wage, there had to be something more to the explanation. This is where the New Keynesians came up with the efficiency wage theory.

The Efficiency Wage Theory
The Efficiency Wage theory can best be explained by using the Henry Ford five dollar ($) a day example. Click Here. Ford’s original motive was to lower worker attrition, which was very high given the monotony of working on an assembly line. People came from all parts of the world to work for Ford and worker attrition fell dramatically and productivity rose, so that in the end, the five dollar a day innovation easily paid for itself.
How it works. Think of a carrot and a stick. The carrot is of course the $5 a day wage, double that of competing jobs. Workers for Ford felt great in that the boss, the Ford motor company, was taking care of their workers better than competing firms. This is the gift exchange motive, the “carrot.” The idea is that if the boss is treating me well, then I am going to treat the boss well by working hard. I had a friend in Orlando, FL that was in the landscaping business. His demand for labor varied according to the size of the job at hand. Sometimes he needed 2 or 3 laborers and sometimes he needed up to 10 laborers. So there was an area in town where the laborers would gather and my friend would pick them up and the first thing he did, before going to the job site, was to take them to Burger King for breakfast. Through the years he had come to the belief that a happy worker with a full stomach works much better than a not so happy worker with an empty stomach. So the breakfast was the ‘carrot’ and isn’t it odd that my friend never took an economics course in his life!
The “stick.” Along with the carrot that arguably makes people work harder and thus, be more productive, there is the stick, which motivates people not to loaf (shirk). The idea here is straightforward, it is extremely costly to shirk since if you get caught and lose your job, your odds of securing another job like the Ford job, was next to zero. Another way to put it is that the opportunity costs of shirking were very high, i.e., the value of not shirking was a five dollar a day job, a wage that was double that of similar jobs. This is the “stick.”
So between the carrot and the stick, a higher real wage will motivate workers to show up to work regularly (less absenteeism) and to work hard. The firm’s profit maximizing condition changes and now includes the concept that a higher real wage will result in higher worker productivity. To formalize, we can model the carrot and the stick with an effort function. (see below). The firm maximizes profits by paying a real wage that maximizes the effort per real wage dollar spent. For example, consider the following real wage - effort relationship (this problem is from the back of Chapter 11).

w (real wage)

E (Effort)




















Given that the firm maximizes profits by maximizing the effort per real wage dollar spent, this firm will choose to pay a real wage of 12 and receive an effort per worker of 15. You may be asking, what exactly does an effort of 15 mean? The amount of effort is a function of the marginal product of labor (MPN). For example, suppose we model the marginal product of labor as follows:

1) MPN = E(100 – N)/15
Note that the MPN is positively related to Effort (E) and negatively related to N, the latter being consistent with the diminishing marginal returns to labor. Given that we maximize profits by maximizing the effort per real wage dollar spent, we will pay a real wage of 12 and receive an effort level from our workers of 15.
So how many workers do we hire to maximize profits? We set the real wage equal to the marginal product of labor, just like we have been doing throughout this course.
2) w = MPN

3) 12 = 15(100 – N)/15

4) N* = 88
So given these conditions, the firm maximizes profits by hiring 88 workers. Note importantly that we have not mentioned labor supply (Ns) throughout our discussion. This is a key feature and is what makes this model so attractive in that labor markets do not have to clear, as they do in the Classical theory. For example, suppose that labor supply is estimated to be:
5) Ns = 80 + 10w
At a real wage of 12, there are 200 workers willing to work. How many will actually be working? 88! There will be 112 workers that are involuntarily unemployed, a feature of the economy that the Classical economists failed to explain. There are two aspects of this efficiency wage theory that need to be emphasized. The first is that the theory suggests that real wages are rigid, the labor market does not necessarily clear and thus, the theory does great at explaining unemployment. The second aspect is that changes labor supply does not effect the amount of people employed (so it does not shift the FE curve) like it does in the Classical model. For example, suppose labor supply changes and is now: Ns = 100 + 10w. The only thing that changes is unemployment, now there will be 132 workers that are unemployed. Use the space below to show all of this graphically (include an effort function as well as a labor market diagram.

Cyclical Properties of the Real Wage
The efficiency wage theory is also capable of explaining the cyclicality of the real wage. Recall that the real wage, according to the business cycle facts, is pro-cyclical. According to the efficiency wage theory, the real wage (the efficiency wage) will be rigid and will only change when the effort function changes. We could argue that the effort function does change over the business cycle. In particular, we would argue that the effort function shifts up in a recession (i.e., people are willing to increase effort at any given real wage) and shifts down in a boom (when unemployment is very low, workers are scarce and thus, there is not much of a stick, the firm is going to keep you anyway!). In terms of the real world, model the change in the effort function during the New Economy (when Unemployment Rates fell below 4%!) and the effort function during the Great Recession (when Unemployment Rates approached 10%). Adding this feature to the efficiency wage theory is very attractive in that real wages are sticky and pro-cyclical according to the business cycle facts, perfectly consistent with the outcome of the efficiency wage theory. Show the pro-cyclical real wage using the effort function in the space below.

Price Stickiness
Another fact that the New Keynesians set out to explain was price stickiness, that is, Prices in the real world appear not to be as flexible as the Classical economists assume. Recall that price stickiness is an immense feature of the Keynesian model since if prices are sticky, then both monetary and fiscal policy will have real effects, that is, the LM curve will not immediately return the economy back to full employment (recall money neutrality relies on perfectly flexible prices). This being the case, the Keynesian’s argue that both monetary and fiscal policy can this exploit this price rigidity and steer the cruise ship into port. If fact, the Keynesians go one step farther and argue that it is the obligation or duty of policymakers to pursue full employment and stable prices, many times referred to as a dual mandate. Click Here for more.
So why are prices sticky? The first observation is that we need to note that it is costly to change prices and thus, we reason that if the marginal cost of changing prices is greater than the marginal benefits of changing prices, then the firm will keep prices constant. The cost of changing prices is referred to as menu costs, referring to the costs of revising and reprinting a menu from a restaurant. Menu costs can explain a bit of price stickiness, but there is more to the story.
Imperfect competition. Implicitly assumed in the Classical model was that all firms fell into the perfectly competitive framework so that firms were price takers. The idea is that when demand or supply conditions changes, there will be an immediate change in the price reflecting these changes. Recall that in a world of perfect competition, firms face a horizontal demand = marginal revenue curve. In other words, the firm can sell as much as they want at the given price, they won’t charge a lower price because that would be irrational and they won’t charge a higher price because if they did, they would sell nothing. Of course, only a small sector of the economy can be characterized as perfectly competitive, the rest is referred to as imperfect competition. Most would agree that monopolistic competition is the most prominent form of competition in the US economy and thus, firms do possess some market power implying that their individual demand curves are downward sloping and thus, they are price setters as opposed to price takers.
Markup Pricing. As you learned in your principles of microeconomics class, the profit maximizing condition in the product markets is to set marginal revenue equal to marginal cost. With a downward sloping demand curve, this profiting maximizing output occurs when the price of your product exceeds the marginal cost of production. We can characterize this reality by setting the price at a markup over marginal costs.
6) P* = (1 + η)MC
Use the space below to show that the price is always above marginal cost in a monopolistically competitive market.

With prices set above marginal costs, the firm acts like a vending machine. That is, suppose that demand increases. Does the firm immediately raise prices? According to Classical economics, prices would rise immediately. But let us consider the costs of raising prices. We have already mentioned the menu costs and of course they are very relevant. But there are other issues. For one, is the shock to demand permanent or temporary? If it is temporary, then it would be best not to change prices and just meet the increase in demand at the same price (i.e., fill up the vending machine more often). If the shock is permanent, then it would be best to raise prices but since it is difficult to identify the temporary vs. permanent nature of shocks, it is rational for the firm to wait, and try to obtain more information before making a pricing decision. Beyond this reality, the firm has to be very aware of market share as in, what are my competitors doing? For example, supposed you own a movie theater and you are contemplating raising prices. If all the other movie theaters in town do not raise their prices, then you may very well lose some market share (and customer loyalty). It might be best for you to meet the additional demand at the same price as long as the price is above the marginal cost of production. This being the case, profits will still rise, even though you may not be maximizing them in the short run. In the long run, given the shock is permanent, prices will adjust, but this entire process will take a while, consistent with the empirical observation that prices are sticky.

Effective Demand for Labor – the final component of Keynesian economics revolves around the effective demand for labor. This concept is very simple yet very powerful. The idea is that the demand for labor is determined by the demand for output. If output falls as it does in a recession, then the amount of labor needed to produce the lower output is less and therefore, workers will be laid off. The solution of course is to stimulate aggregate demand via expansionary fiscal and monetary policy and as you do, you will create jobs, since more workers are needed to satisfy the increased appetite (higher aggregate demand). The effective demand curve for labor is drawn similar to the production function, except we reverse the axes. Use the space below to draw the effective demand for labor.

Keynesian Thoughts on Fiscal vs. Monetary Policy. Keynes much preferred Fiscal policy because he felt it was more reliable. He believe that monetary policy was unreliable since the main channel in which monetary policy works is through investment and durable good consumption.

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