Editing New Keynesian economics (section)

====Menu costs and imperfect competition====

In the 1980s the key concept of using menu costs in a framework of [[imperfect competition]] to explain price stickiness was developed.<ref>{{cite book |author-link=Huw Dixon |first=Huw |last=Dixon |chapter-url=http://huwdixon.org/SurfingEconomics/chapter4.pdf |year=2001 |chapter=The Role of imperfect competition in new Keynesian economics |title=Surfing Economics: Essays for the Inquiring Economist |location=New York |publisher=Palgrave |isbn=978-0333760611 }}</ref> The concept of a lump-sum cost (menu cost) to changing the price was originally introduced by Sheshinski and Weiss (1977) in their paper looking at the effect of inflation on the frequency of price-changes.<ref>{{cite journal |last1=Sheshinski |first1=Eytan |last2=Weiss |first2=Yoram |year=1977 |title=Inflation and Costs of Price Adjustment |journal=[[Review of Economic Studies]] |volume=44 |issue=2 |pages=287–303 |jstor=2297067 |doi=10.2307/2297067}}</ref> The idea of applying it as a general theory of [[Nominal rigidity|nominal price rigidity]] was simultaneously put forward by several economists in 1985–86. [[George Akerlof]] and [[Janet Yellen]] put forward the idea that due to [[bounded rationality]] firms will not want to change their price unless the benefit is more than a small amount.<ref>{{cite journal |last1=Akerlof |first1=George A. |last2=Yellen |first2=Janet L. |year=1985 |title=Can Small Deviations from Rationality Make Significant Differences to Economic Equilibria? |journal=[[American Economic Review]] |volume=75 |issue=4 |pages=708–720 |jstor=1821349 }}</ref><ref>{{cite journal |last1=Akerlof |first1=George A. |last2=Yellen |first2=Janet L. |year=1985 |title=A Near-rational Model of the Business Cycle, with Wage and Price Inertia |journal=[[The Quarterly Journal of Economics]] |volume=100 |issue=5 |pages=823–838 |doi=10.1093/qje/100.Supplement.823 }}</ref> This [[bounded rationality]] leads to inertia in nominal prices and wages which can lead to output fluctuating at constant nominal prices and wages. [[Gregory Mankiw]] took the menu-cost idea and focused on the welfare effects of changes in output resulting from [[sticky prices]].<ref>{{cite journal |last=Mankiw |first=N. Gregory |year=1985 |title=Small Menu Costs and Large Business Cycles: A Macroeconomic Model of Monopoly |journal=[[The Quarterly Journal of Economics]] |volume=100 |issue=2 |pages=529–538 |jstor=1885395 |doi= 10.2307/1885395}}</ref> Michael Parkin also put forward the idea.<ref>{{cite journal |first=Michael |last=Parkin |year=1986 |title=The Output-Inflation Trade-off When Prices Are Costly to Change |journal=[[Journal of Political Economy]] |volume=94 |issue=1 |pages=200–224 |doi= 10.1086/261369|jstor=1831966 |s2cid=154048806 |url=https://ir.lib.uwo.ca/economicsresrpt/782 }}</ref> Although the approach initially focused mainly on the rigidity of nominal prices, it was extended to wages and prices by [[Olivier Blanchard]] and [[Nobuhiro Kiyotaki]] in their influential article "Monopolistic Competition and the Effects of Aggregate Demand".<ref>{{cite journal |last1=Blanchard |first1=O. |last2=Kiyotaki |first2=N. |year=1987 |title=Monopolistic Competition and the Effects of Aggregate Demand |journal=[[American Economic Review]] |volume=77 |issue=4 |pages=647–666 |jstor=1814537 }}</ref> [[Huw Dixon]] and Claus Hansen showed that even if menu costs applied to a small sector of the economy, this would influence the rest of the economy and lead to prices in the rest of the economy becoming less responsive to changes in demand.<ref>{{cite journal |first1=Huw |last1=Dixon |first2=Claus |last2=Hansen |title=A Mixed Industrial Structure Magnifies the Importance of Menu Costs |journal=[[European Economic Review]] |year=1999 |volume=43 |issue=8 |pages=1475–1499 |doi=10.1016/S0014-2921(98)00029-4 }}</ref>

While some studies suggested that menu costs are too small to have much of an aggregate impact, [[Laurence M. Ball]] and [[David Romer]] showed in 1990 that [[real rigidities]] could interact with nominal rigidities to create significant disequilibrium.<ref>Ball, L. and Romer, D. (1990). "Real Rigidities and the Non-neutrality of Money". ''Review of Economic Studies''. Volume 57. pp. 183–203</ref> Real rigidities occur whenever a firm is slow to adjust its real prices in response to a changing economic environment. For example, a firm can face real rigidities if it has market power or if its costs for inputs and wages are locked-in by a contract.<ref>Romer, David (2005). ''Advanced Macroeconomics''. New York: McGraw-Hill. {{ISBN|978-0-07-287730-4}}. pp 380–381.</ref> Ball and Romer argued that real rigidities in the labor market keep a firm's costs high, which makes firms hesitant to cut prices and lose revenue. The expense created by real rigidities combined with the menu cost of changing prices makes it less likely that firm will cut prices to a market clearing level.<ref>Mankiw, N. Gregory (1990).</ref>

Even if prices are perfectly flexible, imperfect competition can affect the influence of fiscal policy in terms of the multiplier. Huw Dixon and Gregory Mankiw developed independently simple general equilibrium models showing that the fiscal multiplier could be increasing with the degree of imperfect competition in the output market.<ref>Huw Dixon (1987). "A simple model of imperfect competition with Walrasian features". ''Oxford Economic Papers'' 39, pp. 134–160.</ref><ref>Gregory Mankiw (1988). "Imperfect competition and the Keynesian cross". ''Economics Letters'' 26, pp. 7–13</ref> The reason for this is that [[imperfect competition]] in the output market tends to reduce the [[real wage]], leading to the household substituting away from [[Consumption (economics)|consumption]] towards [[leisure]]. When [[government spending]] is increased, the corresponding increase in [[Taxation|lump-sum taxation]] causes both leisure and consumption to decrease (assuming that they are both a normal good). The greater the degree of imperfect competition in the output market, the lower the [[real wage]] and hence the more the reduction falls on leisure (i.e. households work more) and less on consumption. Hence the [[fiscal multiplier]] is less than one, but increasing in the degree of imperfect competition in the output market.<ref>{{cite journal | last1 = Costa | first1 = L. | last2 = Dixon | first2 = H. | year = 2011 | title = Fiscal Policy Under Imperfect Competition with Flexible Prices: An Overview and Survey | journal = Economics: The Open-Access, Open-Assessment e-Journal | volume = 5 | issue = 1 | pages = 2011–2013 | doi = 10.5018/economics-ejournal.ja.2011-3 | s2cid = 6931642 | doi-access = free }}</ref>