Joseph Stiglitz’s sticky prices

Financial Mirror (Cyprus) - - FRONT PAGE -

To be sure, many ob­servers re­alised the truth was ac­tu­ally quite dif­fer­ent – that prices, and wages and in­ter­est rates in par­tic­u­lar, were of­ten sticky, and that this some­times pre­vented mar­kets from clear­ing. In labour mar­kets, this meant un­em­ployed work­ers fac­ing pro­longed job searches. But the re­sponse by oth­ers in the field was that what their col­leagues de­scribed as “un­em­ploy­ment” did not truly ex­ist; it was vol­un­tary, the re­sult of stub­born work­ers re­fus­ing to ac­cept the go­ing wage.

Among those who recog­nised the re­al­ity of in­vol­un­tary un­em­ploy­ment were John May­nard Keynes and Arthur Lewis, who in­cor­po­rated it into his model of dual economies, in which ur­ban wages do not re­spond to la­bor-sup­ply gluts and re­main above what ru­ral work­ers earn. Both Keynes and Lewis used the stick­i­ness of prices ex­ten­sively in their work. But even for them, the con­cept was only an as­sump­tion; they never man­aged to ex­plain why wages and in­ter­est rates so of­ten re­sisted the pres­sures of sup­ply and de­mand.

Columbia Univer­sity’s Joseph Stiglitz, who cel­e­brates 50 years of teach­ing this year, solved the puz­zle. In a se­ries of in­no­va­tive pa­pers, Stiglitz picked up some el­e­men­tary facts about the econ­omy that lay strewn about like jig­saw pieces, put them to­gether, and proved why some prices were nat­u­rally sticky, thereby cre­at­ing mar­ket in­ef­fi­cien­cies and thwart­ing the func­tion­ing of the invisible hand. In Stiglitz’s words, the invisible hand “is invisible at least in part be­cause it is not there.”

Stiglitz set out his ar­gu­ment over a re­mark­able ten-year pe­riod. In 1974, he pub­lished a pa­per on labour turnover that ex­plained why wages are rigid. His anal­y­sis has im­por­tant im­pli­ca­tions for de­vel­op­ment eco­nomics, and I have used it of­ten. This was fol­lowed by other im­por­tant work, in­clud­ing a pa­per on credit ra­tioning and in­ter­est-rate rigid­ity (cowrit­ten with An­drew Weiss) and an­other pa­per on ef­fi­ciency wages. And then, in 1984, with Carl Shapiro he pub­lished the de­fin­i­tive work on en­doge­nous un­em­ploy­ment.

Other econ­o­mists’ work – for ex­am­ple, Ge­orge Ak­erlof’s sem­i­nal pa­per on the mar­ket for le­mons – had laid the foun­da­tions for this re­search on price rigidi­ties. But Stiglitz’s pa­pers, pub­lished in the 1970s and early 1980s, shifted the main­stream par­a­digm of the mi­croe­co­nomic the­ory of mar­kets.

The in­tu­ition be­hind some of Stiglitz’s ar­gu­ments about rigid prices is sim­ple. We know that peo­ple of­ten shirk if there is no penalty for do­ing so, and that the com­mon penalty in the work­place is the risk of los­ing one’s job. But if one as­sumes a full-em­ploy­ment equi­lib­rium, as de­scribed in text­books, with the mar­ket work­ing with­out fric­tion, this penalty is in­ef­fec­tive. Threat­en­ing work­ers with the loss of their job will have no ef­fect if they can im­me­di­ately find an­other.

The way to cre­ate in­cen­tives not to shirk is to pay work­ers above the mar­ket wage, making the loss of a job more costly. Of course, if this works for one firm, it will work for oth­ers, and so wages will rise, and even­tu­ally the sup­ply of la­bor will ex­ceed de­mand. In other words, there will be un­em­ploy­ment. And then, even if all firms are pay­ing the same wage, the threat to fire a worker will be ef­fec­tive, be­cause a worker who loses a job will face the risk of re­main­ing un­em­ployed. As a re­sult, the mar­ket will reach an equi­lib­rium where un­em­ploy­ment ex­ists, but wages do not drop. This is, in short, the Shapiro-Stiglitz equi­lib­rium.

An ex­cel­lent sur­vey of this lit­er­a­ture can be found in the 1984 pa­per “Ef­fi­ciency Wage Mod­els of Un­em­ploy­ment,” by Janet Yellen, now Chair of the US Fed­eral Re­serve. (Per­haps some read­ers can even pick up clues on when the Fed will raise rates!)

As in­flu­en­tial as Stiglitz’s re­search has been, this re­mains an area where much more work can be done. One of my frus­tra­tions has been to watch how mon­e­tary pol­icy is made in some de­vel­op­ing economies, where the au­thor­i­ties all too of­ten copy the rules that in­dus­tri­alised coun­tries fol­low,

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