Discuss the rationale behind the WS and PS curves

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Paul Allen        Macroeconomics        B00561027

 Discuss the rationale behind the WS and PS curves.

Introduction

Traditionally markets were assumed perfectly competitive. This assumption has become more unlikely but here are the characteristics of a perfectly competitive market. There are many sellers, many individual buyers, no barrios of entry or exit, perfect knowledge, perfectly mobile factors of production and no externalities. The assumptions of pure competition do not hold in the vast majority of real world markets. This has led a progressive new wave of thinking usually associated with New Keynesian the theory of imperfectly competitive markets.

Perfect Markets

In perfectly competitive markets, producers take prices as given; in imperfectly competitive markets, producers have some ability to choose the prices they charge. In both kinds of markets, there is a short - run positive relationship between prices and output, but for slightly different reasons. Let’s start with the behaviour of producers in perfectly competitive markets; remember, they take the price as given. Imagine that, for some reason, the aggregate price level falls, which means that the price received by the typical producer of a final good or service falls. Because many production costs are fixed in the short run, production cost per unit of output doesn’t fall by the same proportion as the fall in the price of output. So the profit per unit of output declines, leading perfectly competitive producers to reduce the quantity supplied in the short run. In perfectly competitive markets, producers take prices as given.

Let’s start with the behaviour of producers in perfectly competitive markets; remember, they take the price as given. Imagine that, for some reason, the aggregate price level falls, which means that the price received by the typical producer of a final good or service falls. Because many production costs are fixed in the short run, production cost per unit of output doesn’t fall by the same proportion as the fall in the price of output. So the profit per unit of output declines, leading perfectly competitive producers to reduce the quantity supplied in the short run. (Krugman, Ray & Anderson, 2010)

Why in the view of macroeconomists why doesn’t the classical view of perfectively competitive markers describe how the economy behaves? New Keynesian economics, a set of ideal which has become more prominent during the latter end of the 20thcentury provides us with the reasoning. It argues that market imperfections interact to make many prices in the economy temporarily sticky. Ex. New Keynesians argument highlights that monopolists don’t have to be too careful about setting prices exactly right. If the price is set slightly too high, they’ll lose some sales but make more profits on each sale. If the set the price too low, they’ll reduce the profit per sale but sell more. Thus showing even small costs to changing prices can lead to substantial price stickiness and make the economy as a whole behave in a Keynesian fashion.

The conditions of an imperfectly competitive market;

Consumers may have monopsony powers against suppliers because of high purchasing powers. An example of this would be a firm like Walmart whose economies of scale allow them to purchase whole sale goods in bulk for a lower price than its competitors. This agent of the imperfectly competitive market is a price setter.

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What is the significance of agents becoming price setters as opposed to price takers? In product markers now firms are setting the price pegged to elasticity of demand which is dependant partly due to the extent of competition.  Labour markets now are wage setters. Trade unions are setting wages through collective bargaining, this will be dependent on level of current employment when the economy has high employment trade unions powers diminish as workers bargaining power is weak. When assuming price setting as opposed to price taking behaviour changes. We analyse macroeconomic phenomena such as inflation and unemployment differently.

 

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