A number of recent contributions to macroeconomics have focused on the idea that market economies can settle at an inefficiently low level of employment because of lack of coordination among market participants. These models of `underemployment equilibria' can be distinguished by the specific form that externalities take. Demand spillovers across markets give rise to externalities if firms behave non-competitively, i.e. if they react to quantity as well as price signals. In this case, each firm would be better off if the others decided to expand their output, as this would raise aggregate income and thus the demand for its own product. If that were to happen, the firm would itself want to expand its output, so that equilibrium production decisions are positively correlated.
In Discussion Paper No. 280, Research Fellow Marco Pagano presents a model of underemployment equilibrium based on `demand spillovers' and imperfectly competitive markets. Pagano uses the overlapping-generations framework, which allows an explicit treatment of households' intertemporal decisions and labour supply choices. By treating saving decisions explicitly, Pagano is able to analyse the impact of fiscal policy on consumption and saving in an underemployment equilibrium.
In the model there are at each date firms, young households and old households. The existence of `brand qualities' gives rise to imperfectly competitive goods markets. Firms face the choice of which brand quality to produce. In addition to the markets corresponding to the various brands, there is a competitive market for labour, which clears through nominal wage adjustments, and a market for capital, which sets the equilibrium level of nominal interest rate.

People live for two periods. In the first, they choose whether or not they want to work, how much they want to save for the subsequent period, and which brand they want to consume in the current period. In their second period, they simply spend their savings, possibly switching to a different brand. The number of firms is assumed to depend on the level of profits, while the mark-up rate depends inversely on the number of firms. The assumption of a set-up cost creates an entry barrier that endogenously limits the number of firms operating at zero-profit equilibria. Without this assumption, at zero profits the number of firms would be unbounded and the imperfectly competitive nature of the economy would vanish.


Pagano finds that `Keynesian' fiscal policy prescriptions are reversed in his model, despite the existence of underemployment equilibria. Policies that lower national saving are detrimental rather than beneficial, in that they lower employment, the real wage, and the number of firms operating in the economy. A fiscal expansion consisting of a debt-financed increase in public consumption, for instance, is counterproductive, whereas a balanced-budget reduction of spending or a retirement of public debt are beneficial. This contrasts sharply with the Keynesian prescription that in a depressed economy fiscal policy should be used to stimulate the consumption component of aggregate demand in order to raise employment and welfare. Although these results would not necessarily hold in more general models, Pagano concludes that they highlight the importance of fully specifying the model of the macroeconomy, before drawing policy conclusions from models of underemployment equilibria


Imperfect Competition, Underemployment Equilibria and Fiscal Policy
Marco Pagano

Discussion Paper No. 280, December 1988 (IM)