Chapter 7,The Analysis of Price
Determination
Gang Gong
Copyright Notes:This electronic file is
only used as a lecture notes for the
student in this class,It is not allowed to be
used for presentation anywhere else
without the permission from the author.
Introduction
? The objective of this chapter is to discuss
how price is determined in Keynesian
analysis.
? Some textbooks would like to refer the
analysis in this chapter as the medium
analysis in contrast to short run analysis,
This is because in the short run the price is
assumed to be fixed,and therefore nothing
we can say about the price determination.
Introduction
? Generally speaking,Keynesian economics
does not exclude the market condition
(excess demand or supply) as a factor to
determine price,Yet in addition to the
market condition,the cost of production is
also important in price determination,This
seems to be contrast to the Neo and New
classical analysis according to which only
the first is emphasized.
Wage Determination
? In reality,wage may set by many ways.
– Collective bargaining between firms and union
may be one way,
– The government may set up a minimum wage
rate,
– Firms may simply decide a wage rate according
to the market condition,
– Or a firm may even pay an efficiency wage (the
wage level beyond the condition) to keep the
worker work efficiently,
Wage Determination
? Generally,one could have the following
equation regarding the wage determination:
? where is the expected price,u is the
unemployment rate and z represent other
factors,In particular,one could assume
),( zugPW e?
eP
PP e ?
Wage Determination
? Note that the above way of wage
determination capture our two basic forces
(market condition and cost) in
determination of price.
Price Determination
? In macroeconomics,the cost of a product in
general is reflected by the wage,Therefore
one could write the price equation as
P = (W+q)(1+μ)
where q could be regarded as the production
cost other than wage; μ the markup over the
cost W+q,
Price Determination
? It should be noted that there is no reason to
believe μ and q are always fixed,One could
think of μ as being a reflection of the
market condition in general industry while q
as being determined by import price,change
in productivity among others,All these can
be regarded as supply shock.
Price Determination
? There is no reason to believe μ is fixed,
Indeed,one could think of μ as being a
reflection of the market condition in
general industry.
? Thus,given the unemployment rate,one
could determine the price and wage
simultaneously by the wage and price
equations.
Putting All Markets Together
? We are now ready to put all markets
together and construct a hypothetical
“general” equilibrium model with one
industry:
Putting All Markets Together
? The model should includes the following
equations:
IS curve,
LM curve:
the production function,Y = F(N)
the wage equation:
the price equation,P = (W+q)(1+μ)
the definition of u,u = 1 - N/L
? ? ? ?)1(1/)( tcGifAY ?????
PMhikY /??
)( uPgW ?
Putting All Markets Together
? The solution of this system can often be
represented by the so-called aggregate
demand and aggregate supply analysis,
? In particular,the IS and LM curves
represents an aggregate demand curve since
from them one can find a negative relation
between P and Y.
Putting All Markets Together
? The other four equations form an aggregate
supply since from them one can find a
positive relation between Y and P,(question,
how can it be understood as an aggregate
supply curve?)
? The solution of P and Y is thus be
determined by the intersection of demand
and supply curve.
Determination
Gang Gong
Copyright Notes:This electronic file is
only used as a lecture notes for the
student in this class,It is not allowed to be
used for presentation anywhere else
without the permission from the author.
Introduction
? The objective of this chapter is to discuss
how price is determined in Keynesian
analysis.
? Some textbooks would like to refer the
analysis in this chapter as the medium
analysis in contrast to short run analysis,
This is because in the short run the price is
assumed to be fixed,and therefore nothing
we can say about the price determination.
Introduction
? Generally speaking,Keynesian economics
does not exclude the market condition
(excess demand or supply) as a factor to
determine price,Yet in addition to the
market condition,the cost of production is
also important in price determination,This
seems to be contrast to the Neo and New
classical analysis according to which only
the first is emphasized.
Wage Determination
? In reality,wage may set by many ways.
– Collective bargaining between firms and union
may be one way,
– The government may set up a minimum wage
rate,
– Firms may simply decide a wage rate according
to the market condition,
– Or a firm may even pay an efficiency wage (the
wage level beyond the condition) to keep the
worker work efficiently,
Wage Determination
? Generally,one could have the following
equation regarding the wage determination:
? where is the expected price,u is the
unemployment rate and z represent other
factors,In particular,one could assume
),( zugPW e?
eP
PP e ?
Wage Determination
? Note that the above way of wage
determination capture our two basic forces
(market condition and cost) in
determination of price.
Price Determination
? In macroeconomics,the cost of a product in
general is reflected by the wage,Therefore
one could write the price equation as
P = (W+q)(1+μ)
where q could be regarded as the production
cost other than wage; μ the markup over the
cost W+q,
Price Determination
? It should be noted that there is no reason to
believe μ and q are always fixed,One could
think of μ as being a reflection of the
market condition in general industry while q
as being determined by import price,change
in productivity among others,All these can
be regarded as supply shock.
Price Determination
? There is no reason to believe μ is fixed,
Indeed,one could think of μ as being a
reflection of the market condition in
general industry.
? Thus,given the unemployment rate,one
could determine the price and wage
simultaneously by the wage and price
equations.
Putting All Markets Together
? We are now ready to put all markets
together and construct a hypothetical
“general” equilibrium model with one
industry:
Putting All Markets Together
? The model should includes the following
equations:
IS curve,
LM curve:
the production function,Y = F(N)
the wage equation:
the price equation,P = (W+q)(1+μ)
the definition of u,u = 1 - N/L
? ? ? ?)1(1/)( tcGifAY ?????
PMhikY /??
)( uPgW ?
Putting All Markets Together
? The solution of this system can often be
represented by the so-called aggregate
demand and aggregate supply analysis,
? In particular,the IS and LM curves
represents an aggregate demand curve since
from them one can find a negative relation
between P and Y.
Putting All Markets Together
? The other four equations form an aggregate
supply since from them one can find a
positive relation between Y and P,(question,
how can it be understood as an aggregate
supply curve?)
? The solution of P and Y is thus be
determined by the intersection of demand
and supply curve.
