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Monopolistic Competition and The Efficient Aggregate Demand
Monopolistic Competition and The Efficient Aggregate Demand
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Monopolistic Competition and the Effects
of Aggregate Demand
By OLIVIERJEANBLANCHARDAND NOBUHIROKIYOTAKI*
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648 THEAMERICANECONOMICREVIEW SEPTEMBER1987
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VOL. 77 NO. 4 AND KIYOTAKI:
BLANCHARD COMPETITION
MONOPOLISTIC 649
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650 THE AMERICAN ECONOMIC REVIEW SEPTEMBER 1987
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VOL. 77 NO. 4 AND KIYOTAKI:
BLANCHARD COMPETITION
MONOPOLISTIC 651
The demandfor each type of good relative An increase in the aggregatereal wage
to aggregate demand is a function of the (W/P) leads household j to increase its
ratio of its nominal price to the nominal labor supply, thus to decrease its relative
price index, the price level, with elasticity wage (W//W). An increasein aggregatede-
(- 0). The demand for labor by firms is a mand leads, if ,B is strictly greater than
deriveddemandfor labor;it dependson the unity, to an increasein the relativewage. If
demand for goods. The demand for each ,B is equal to unity, if the marginaldisutility
type of labor is a functionof the ratio of its of labor is constant, workerssupply more
nominal wage to the nominal wage index, labor at the same relativewage, in response
with elasticity (- a). to an increasein aggregatedemand.
We now consider the price rule. Given the
price level, each firm is a monopolist and C. SymmetricEquilibrium
decidesaboutits real(or relative)priceP1/P.
An increase in the real wage (W/P) shifts Equilibriumand symmetry,both across
the marginalcost curve upward,leading to firms and acrosshouseholds,impliesthat all
an increasein the relativeprice.An increase relativeprices and all relativewagesmustbe
in aggregatedemandshiftsthe demandcurve equal to unity. Thus, using Pi = P for all i
for each product upward;if the firm oper- and W4/=W for all j, and substitutingin
ates under decreasingreturns,the marginal equations(10) and (11) gives
cost curveis upwardslopingand the relative
price increases.Under constantreturns,the (12) (P7W) = (0/(O-1))KPYa-l;
shift in demandhas no effecton the relative
price. (13) (W1/P) = (a1/(a-1))KWYa(fl-1).
We finally consider the wage rule, equa-
tion (11). We can think of households as Equation(12), obtainedfrom the individ-
solving theirutility-maximization problemin ual price rules and the requirementthat all
two steps. They first solve for the allocation prices be the same,givesthe pricewageratio
of their wealth, includinglabor income,be- (P7W) as a function of output. If firms
tween consumptionof the differentproducts operateunderstrictlydecreasingreturns,the
and real money balances.Afterthis step, the price wage ratio is an increasingfunctionof
assumption that utility is linearly homoge- the level of output. Equivalently,the real
neous in consumptionand real money bal- wage (W/P) consistentwith firms'behavior
ances implies that utility is linearin wealth, is a decreasingfunctionof output.We shall
thus linear in labor income.The next step is refer to equation(12) as the "aggregateprice
to solve for the level of laborsupplyand the rule."
nominal wage. Given that utility is linearin Equation(13), obtainedfrom the individ-
labor income, we can thinkof householdsas ual wage rules and the requirementthat all
monopolists maximizingthe surplus from wagesbe the same,givesthe realwage(W/P)
supplying labor. Formally,if ILdenotes the as a functionof output.If /3is strictlygreater
constant marginal utility of real wealth, than unity, that is, if workershaveincreasing
householdssolve in the secondstep: marginal disutility of work, an increasein
output, that leads to an increase in the
max ,u(Wj/P)ANj- NJ derived demand for labor, requiresan in-
crease in the real wage. The real wage con-
sistent with households'behavioris an in-
Nj = K,Y( W/W) creasingfunctionof output.We shallreferto
equation(13) as the "aggregatewage rule."
The real wage relevant for worker j is Equations(12) and (13) give (W/P) and
Wj/P, which we can write as the product Y. The value of (M/P) follows from (5).
(Wj/W)(W/P). The demand for labor of The equilibriumis characterizedgraphically
type j is a function of the relative wage in Figure 1. As (12) and (13) are log-linear,
(Wj/W) as well as of aggregatedemand. we measure log(W/P) on the vertical axis
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652 THEAMERICANECONOMICREVIEW SEPTEMBER1987
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VOL. 77 NO. 4 AND KIYOTAKI:
BLANCHARD COMPETITION
MONOPOLISTIC 653
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654 THE AMERICAN ECONOMIC REVIEW SEPTEMBER 1987
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VOL. 77 NO. 4 AND KIYOTAKI:
BLANCHARD COMPETITION
MONOPOLISTIC 655
we shall concentrateon changesin nominal the same is true of the utility of a worker
money. But then it is clearthat, as equations who does not adjusthis relativewage. Thus
(12) and (13) are homogeneousof degree second-ordermenu costs may preventfirms
zero in P, W, and M, nominal money is and workers from adjustingrelative prices
neutral, affecting all nominal prices and and wages. The implicationis that nominal
wages proportionately,and leaving output prices and nominal wages do not adjust to
and employment unchanged. Thus some- the change in nominal money. The second
thing else is needed to obtain real effects of part of the argumentis to show that the
nominal money. We examinethe effects of changein real moneybalanceshas first-order
costs of price settingin the next section. effects on welfare;we show that it is indeed
first order, and of the same sign as the
III. Menu CostsandRealEffectsof change in money. The argumenthas very
NominalMoney much the same structureas the aggregate
demandexternalityargumentof the previous
We now introducesmall costs of setting section; this coincidence is not accidental
prices, small "menu" costs. Akerlof and and we returnto it below.
Yellen (1985a, b) and Mankiwhave shown The firstpart is a directapplicationof the
how such small costs can lead to large wel- envelope theorem. Considerfirms first. Let
fare effectsin imperfectlycompetitiveecono- Vi be the value of firm i. Vi is a functionof
mies." We apply their argument to the Pi as well as of P, W, and M (Vi=
specificcontext of monopolisticcompetition, Vi(Pi,P, W, M)). Let ViJ*be the maximized
derive welfare and output effects as explicit value of firm i, after maximizationover Pi;
functions of the underlyingparameters,and Vi* =Vi *(P, W, M). The envelope theorem
relate these effects to the externalityiden- then says that
tified earlier.
dVl*/dM = aVadM + (daViaPJ)(dPIydM)
A. TheEffectsof SmallChangesin
NominalMoney = av1/aM.
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656 THEAMERICANECONOMICREVIEW SEPTEMBER1987
petitive equilibrium.
There is clearly a close relationbetween - - price ruleof
(Pi(P1
loglog
the aggregate demand externality and the /M)
~~~~~~~~~~th
firm
Pi /M=Ri(P/M)
menu cost argument of this section. This re-
log (Pi/ M)
lation is most simply shown in the special --
Figure 3 plots the price chosen by firm i absent menu costs, each firm would find in
as a functionof the pricelevel,both as ratios its interest to increase its price until the
to nominal money. In the presenceof mo- economy had returnedto point E. In the
nopoly power,the pricerulehas slopesmaller presenceof menu costs,however,thesemenu
than one. We also drawiso-profitloci, giving costs, if largeenough,can preventthis move-
combinations of (Pi/M) and (P/M) that ment back to E, so that the economy re-
yield the same level of real profit for the mains at E' and all firmsend up with higher
firm.'5The symmetricmonopolisticallycom- real profits. (A similar argument,although
petitive equilibriumis given by the intersec- slightlymore complicated,holds for the gen-
tion of the price rule and the 450 line, point eral model. We shall not presentit here.)
E. Point A gives the highestrealprofitpoint It is also importantto note the specificrole
on the 450 line. played by money in this section. The pres-
The aggregate demand externalityargu- ence of an aggregatedemandexternalitydoes
ment can then be statedas follows.Consider not depend on the nature of the nonpro-
a small proportional decrease of prices, keep- duced good, or on the nature of the
ing nominal money constant. The equi- numeraire.The resultsof this sectiondepend
libriummoves from point E to a point like on money being the nonproducedgood and
E' along the 450 line. The profit of each firm the numeraire.That moneyis the numeraire
rises with the increasein aggregatedemand. implies that, given menu costs, unchanged
However,in the absenceof coordination,no prices and wages mean unchangednominal
firm has an incentiveto reduceprices away prices and wages.Thatmoneyis the nonpro-
from the equilibriumpoint E. duced goods impliesthat, as the government
The menu cost argumentconsidersinstead can vary the amount of nominalmoney, it
a small increase in nominal money. At the can, if nominal prices and wages do not
initial set of prices, real money balances adjust, change the amount of real money
would increaseand the economywouldmove balances, the real quantity of the nonpro-
from point E to a point like point E'. But, duced good.
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VOL. 77 NO. 4 AND KIYOTAKI:
BLANCHARD MONOPOLISTIC
COMPETITION 657
response to the change in money (private where (0 - 1)/Oa is the initial shareof wage
costs, for short) are no longernegligibleand income in GNP.
depend on the parametersof the model. We If ,B is close to unity, that is, if the elas-
now investigatethis dependence. ticity of the marginaldisutility of labor is
The privatecosts faced by a firmdepends close to unity, privatecosts of not adjusting
on the size of the demandshiftsas well as on wages are small; in the limit, if marginal
the two parametersa and 9. As we have disutility of labor is constant,privatecosts
seen, these costs are of second order in re- are equal to zero. If a is very large, if
sponse to a change in aggregatedemand, differenttypes of labor are close substitutes,
thus roughly proportionalto the squareof privatecosts of not adjustingwagesare high.
the change in aggregatedemand.More pre- Table 1, Part a, gives the size of menu
cisely, define L(A; a, 9) to be the private costs as a proportionof the firm'srevenues
opportunity cost to a firm expressedas a (GNP produced by the firm) that are just
proportion of initial revenues, associated sufficientto preventa firmfromadjustingits
with not adjustingits price in responseto a price in response to a change in demand;
changeof 100A%in aggregatedemand,when Table 1, Part b, gives the size of menu costs
all other firms and households keep their as a proportionof initialconsumption(GNP
prices and wages unchanged.Then, by sim- consumedby the worker)that arejust suffi-
ple computation,we get cient to preventa workerfrom adjustinghis
(her)wage.
_
L(A; at,0) = (a-_1)2( 1)] Thus, given the unit elasticityof aggregate
demandwith respectto real moneybalances
/[2(1+ 0(a-1))] }A2 +0(A2) and the assumptionthat all otherpriceshave
not changed, Part a of Table 1 gives the
where 0(A2) is of thirdorder. private costs associatedwith not changing
The closer a is to one, thatis, the closerto pricesin the face of 5 and 10 percentchanges
constant returns to scale, the smaller the in demand to the firm.The main conclusion
privatecost. In the limit,if a is equalto one, is that very small menu costs, say less than
then privatecosts of not adjustingpricesare .08 percentof revenues,may be sufficientto
equal to zero as the optimal responseof a prevent adjustment of prices. Results are
monopolist to a multiplicativeshift in iso- qualitativelysimilar for workers.Part b of
elastic demandunderconstantmarginalcost Table 1 gives the privatecosts of not chang-
is to leave the priceunchanged.Thusprivate ing wages in responseto changesof + 5 and
costs are an increasingfunctionof a. They +10 percent in the demand for goods. It
are also an increasing function of 9; the assumesthat a is equalto 1.1, so thatchanges
higher the elasticityof demandwith respect in the derived demandfor labor are of 5.5
to price, the higher the privatecosts of not and 11 percent approximately.We expect /B
adjustingprices. to be higherthan a so that Partb of Table 1
Exactly the same analysis applies to looks at valuesof /3between1.2 and 1.6. For
workers.The two importantparametersfor values of ,B close to unity, requiredmenu
them are ,B and a. If we definethe function costs are again very small; as /3 increases
L in the same way as above, the private however,requiredmenu costs become non-
opportunitycost to a worker(measuredin negligible: for /3= 1.6 and a 11 percent
terms of consumption and expressedas a change in demand,they reach.45 percentof
proportion of initial consumption),associ- initial consumption,a numberwhich is no
ated with not adjustingthe wage in response longer negligible.
to a change of 100A%in aggregatedemand, The more relevantcomparison,however,
when all other firms and householdskeep at least from the point of view of welfare,is
their prices and wages unchanged,is given between private costs and welfare effects,
by that is, the change in utility resultingfrom
the changesin output,employment,and real
r{1 1. D _)
[(O _1)/a L(.l A)a money that are impliedby a changein nomi-
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658 THEAMERICANECONOMICREVIEW SEPTEMBER1987
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VOL. 77 NO. 4 AND KIYOTAKI:
BLANCHARD COMPETITION
MONOPOLISTIC 659
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660 THEAMERICANECONOMICREVIEW SEPTEMBER1987
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VOL. 77 NO. 4 AND KIYOTAKI:
BLANCHARD MONOPOLISTIC
COMPETITION 661
Aggregatedemanddependson realmoney
17Analternativeis to assumethat fixed costs for a balances, the ratio of nominalmoney to the
given firmare in the formof othergoods.A convenient price level. Under constant retums with a
assumptionis to assume that the fixed cost is a CES
function of all goods, with elasticityof substitution9. fixed markupof prices on wages, aggregate
This assumptioninsuresthat the demandfunctionsfor demand is thereforea functionof the ratio
goods still have elasticity0. of nominal money to the nominal wage,
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662 THEAMERICANECONOMICREVIEW SEPTEMBER1987
x (W*/W)1-0(M/W)
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VOL. 77 NO. 4 AND KIYOTAKI:
BLANCHARD COMPETITION
MONOPOLISTIC 663
entry would occur and unemploymentsub- tending the model to look at the dynamic
side.21 effectsof aggregatedemandon outputin the
presenceof menu costs.
V. Conclusion The firstis that we haveassumedall prices
to be initially equal and set optimally.In a
The results of this paper are tantalizingly dynamic economy and in the presence of
close to those of traditionalKeynesianmod- menu costs, such a degeneratepricedistribu-
els: under monopolisticcompetition,output tion is unlikely.But,if pricesare initiallynot
is too low, because of an aggregatedemand all equal or optimal,it is no longer obvious
externality. This externality,together with that even a small changein nominalmoney
small menu costs, impliesthat movementsin will leave all pricesunaffected.It is no longer
demand can affect output and welfare. In obvious that money,or aggregatedemandin
particular,increasesin nominal money can general,will have largeeffectson output.
increase both output and welfare. In the The second is that, even if nominalmoney
presenceof fixed costs, output,productivity, has large effects on output, it must be the
and profitabilitymove in the same direction. case that money is sometimes unantic-
We believe these resultsto be importantto ipatedly high, sometimes unanticipatedly
the understandingof macroeconomicfluc- low. When money is high, output increases
tuations; we want to point out the obvious and so does welfare to a first order.When
limitationsof the analysisas it stands. money is low, output decreasesand so does
The scope for small menucosts to lead to welfare,again to a firstorder.These welfare
large output effects in our model depends effects would appearto cancel out to a first
critically on the elasticity of labor supply order. It is thereforeno longerobviousthat,
with respect to the real wage being large even if menu costs lead to largeoutputfluc-
enough (on (/3-1) being small). Evidence tuations, the welfare loss of those fluctua-
on individuallabor supplysuggestshowever tions exceeds the menucosts whichgenerate
a small elasticity. Thus the "menu cost" them.
approachruns into the same problemas the Fortunately,all theseissuesare the subject
imperfect information approach to output of active research.Recent developmentsare
fluctuations;neithercan easilygeneratelarge reviewedin Blanchardand Rotemberg.
fluctuationsin outputin responseto demand
if the real wage elasticityof labor supplyis APPENDIX
low. As in the imperfectinformationcase,
the theorymay be rescuedby the distinction This Appendix derives the market equi-
between temporaryand permanentchanges librium conditions (5) to (11) given in the
in demand.Anotherpossibilityis thatunions text. It proceeds in three steps. The first
have a flatterlabor supply than individuals, derives the demand functionsof each type
or do not representthe whole labor force. of labor and each type of productby solv-
More likely, the assumption that labor ing part of the maximizationproblems of
markets operate as spot markets(competi- firms and households.These functionshold
tive or monopolistically competitive) will whetheror not prices and wages are set by
have to be abandoned.22 workers and firms at their profit or utility
The analysisof this paperis purelystatic. maximizinglevel. The second derives price
There are two main issues involved in ex- rules from firms' profit maximizationand
wage rules from workers'utility maximiza-
tion. The third characterizesmarket equi-
librium.
21This is our interpretation of Weitzman's argument
that increasing returns are a necessary condition for A. Demands for Productand Labor
unemployment to persist. Types
22This is indeed the direction taken by Akerlof and
Yellen (1985b) who formalize the goods market as
monopolistically competitive and the labor market using (a) Demand for product of type i. In
the "efficiency wage" hypothesis. order to maximize utility, each household
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664 THEAMERICANECONOMICREVIEW SEPTEMBER1987
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VOL. 77 NO. 4 AND KIYOTAKI:MONOPOLISTIC
BLANCHARD COMPETITION 665
n
-
(A12) Vi= Pry,- E WjNij, X F (Pi/P) alY.
j =1
subject to the cost function (A8) and the If all firmschoose the same (not necessarily
demand function for its product(A5). Solv- optimal)price, this reducesto
ing the above maximizationproblemgives
(A19) N= [nl/(1 Uml a]ya
(A13) Pi1P= [((01(0#-l))n11(l -?)am1 a
Substituting N from equation (A19) into
X (W/P) Y x-1I1A1 +O(Ca- 1)). (AlO) gives the demandfunctionfor laborj,
equation (8) in the text. Note that the de-
Equation(A13) impliesthatthe priceis equal mand functionsfor goods and labor,and the
to 0/(6 -1) times the marginalcost. Equa- relation between aggregatedemandand real
tion (A13) is equation(10) in the text. money balances,have been derivedwithout
(b) Taking as given prices and other use of the price and wagerulesand therefore
wages, each householdchoosesits wage and hold whetheror not wagesand pricesare set
labor supply so as to maximizeutility.Using optimally.
(A3), SubstitutingN from equation(A19) into
equation(A16) gives the wage rule,equation
(A14) Uj= ,IjIP-N (11) in the text. This completesthe deriva-
tion.
subject to the demandfor its type of labor
(AIO)and the budgetconstraint: REFERENCES
m
Akerlof,GeorgeandYellen,Janet,(1985a) "Can
(A15) Ij=WJNJ+ E fj+Mj.
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(/(- )(/n-) and _ _, (1985b) "A Near-
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