Economists have long puzzled over why prices often remain rigid in the face of changes in demand, since substantial fluctuations in output and employment are then required to clear product markets instead. In Discussion Paper No. 959, Assar Lindbeck and Programme Director Dennis Snower develop a model in which such price inertia arises out of lags in the production process. Final goods sold to consumers are typically made from intermediate goods purchased from other producers, who may in turn have purchased inputs from yet other producers and so on all the way back to the raw materials. Production also takes time, so the intermediate goods used by a producer of final goods at any particular time will have originated at various points in the past. Such producers therefore precommit to their selling prices without knowing with any accuracy how the prices of the goods they purchase or the wages they pay their workers will reflect demand conditions when they finally sell their own output. If they systematically underestimate the strength of changes in demand conditions, they will change prices by less than they should, and the resulting price rigidity implies that quantities must bear the burden of adjustment. Lindbeck and Snower argue that fully anticipated demand changes are virtually inconceivable when final output prices depend on intermediate input prices which depend in turn on nominal wages and hence in turn on final goods prices and they apply this framework to demonstrate that temporary changes to aggregate demand may induce persistent effects on prices (and quantities). These effects may be magnified further if nominal wages are also rigid.

In Discussion Paper No. 960, Lindbeck and Snower develop an insider-outsider model in which the existence of labour turnover costs impedes both outsiders' entry into and insiders' exit from employment. This increases insiders' market power by raising their chances of retaining employment relative to outsiders' chances of gaining employment at any given wage, and the insiders are assumed to pursue their own interests in the wage negotiation process, from which the outsiders are to some extent excluded. Lindbeck and Snower use this model to account for three stylized facts about labour markets: first, all unemployment rates exhibit persistence, which is greater in Europe than in the US; second, the average unemployment rate was higher in the US than in Europe throughout the 1950s and 1960s, but the opposite has applied in the 1980s; and third, the long-run unemployment rate has remained within a narrow range of 2-8% in the long run.

Lindbeck and Snower argue that excluding outsiders from wage setting reduces overall labour demand, while turnover costs also reduce labour markets' speed of adjustment, although some hiring and firing nevertheless takes place, so hysteresis is not complete. Greater persistence in Europe relative to the US reflects the facts that employment protection legislation is more widespread, that most European countries have more homogeneous labour forces so that workers are less likely to quit, and that their labour forces have displayed slower growth. The trend rise of unemployment in Europe relative to the US mainly reflects the role of persistence, as the after-effects of the recessions of the 1970s and 1980s have been more strongly felt in Europe. The long-run stability of the unemployment rate, despite its inverse short-run relationship with productivity and massive rises in both productivity and the overall size of the labour force over the longer run, is compatible with an insider-outsider model in which wage-setting depends only on hiring rates and not on the size of the labour force or productivity. Lindbeck and Snower note in conclusion that various models of non-clearing labour markets may account for some of these stylized facts, but only the insider-outsider model is consistent with all of them.

Price Inertia and Production Lags
Patterns of Unemployment: An Insider-Outsider Analysis
Assar Lindbeck and Dennis J Snower

Discussion Papers Nos. 959-60, July 1994 (HR)