Describe the main differences between the Sticky-Price-Model and the Incomplete-

Question

Describe the main differences between the Sticky-Price-Model and the Incomplete-Information-Model. Focus specifically on

i) The assumption regarding the market structure for the firms

ii) The assumption regarding the level of information of the actors in the model

iii) The implication for the main story:

Describe the link between the price level and output that arises from the model in your own words. Basically, answer the question "Why does the AS curve slope upward?" twice: once for each model.

Explanation / Answer

the economy tells us that in unionized industries, nominal wages are usually set in advance and codified in contracts. Even in nonunionized industries, moreover, there may be analogous implicit arrangements. Many workers have an implicit understanding with their employers that their salaries are reviewed once a year, even if they have no explicit contract stating so. Workers’ salaries are not changed with every event that alters their employers’ profits. The sticky-wage model starts with the presumption that when a firm and its workers sit down to bargain over the wage, they have in mind some target real wage upon which they will ultimately agree. The level of this real wage depends upon the relative bargaining strengths of the firm and its workers, on the presence of efficiency-wage considerations, and so forth. The level of employment at this real wage thus corresponds to full employment (L _ ), as summarized in earlier analysis. But the contract to which they ultimately agree is written in terms not of the real wage but of the nominal wage. To set the nominal wage, the firm and the workers also form an expectation of the general price level. They ultimately set the nominal wage using the formula W = × EP, where is the target real wage. Since the wage is set in advance in a contract, the actual price level may turn out to be different from the expected price level. Suppose, in accordance with the typical features of contracts, that firms have the right to choose the level of employment. They choose this, as usual, by equating the marginal product of labor to the actual real wage: MPL = W/P = × (EP/P). We can then write the demand for labor as L = Ld (W/P). Note that Ld () = L _ ; in other words, employment will be at the natural rate when the actual real wage equals the target real wage. Output is determined in the usual way by substituting this amount of labor into the production function: Y = F(K _ , L) = F(K _ , Ld ( × (EP/P))). Notice first that if EP = P, then W/P = , so Ld (W/P) = L _ and Y = Y _ . Now suppose that the actual price turns out to be higher than was anticipated. Then the actual real wage is lower than anticipated. Labor is cheaper, so firms will employ more workers and output will increase. Exactly the opposite is true if the actual price is lower than expected. Firms are getting less revenue for their output than they anticipated, so they cut back production. We can illustrate this in terms of the labor market. An alternative representation looks at the market for labor with the nominal wage on the vertical axis. In this case, the labor demand curve shifts when the actual price level changes: The model implies that we can represent the aggregate supply curve as Y = Y _ + (P – EP). (This is an approximation of the true aggregate supply curve implied by the model, which says that deviations of output from Y _ depend on P/EP.)1 This model of aggregate supply turns out to have a serious flaw that suggests it cannot be the key or sole source of an upward-sloping aggregate supply relation - ship. According to the theory, firms hire more labor and produce more output when the real wage is low. If this were the explanation of business-cycle fluctuations, then we should expect to see a countercyclical real wage (that is, a real wage that rises when output falls, and vice versa). In reality, the real wage seems to be acycli - cal or slightly procyclical, although measurement problems preclude a definitive conclusion.

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