Neo Keynesian Economics (NKE)

Major drawback of the Keynesian System: It lacks Microeconomic Foundations

Three important differences in the approach to understand the systems

Earlier K	NKE
Perfect competition	Imperfect competition1
Rigidity in Money Wage (Wage Stickiness)	Rigidity is all about Product Price (Price Stickiness)
Nominal Variables $W$	Real Variables $W/p$

Sticky Price Model (Menu-Cost Model)

In perfect competition, $P=D=S$ i.e. when demand falls, the seller would like to sell at a low price since, he wants to regain those consumers.

But in imperfect competition, when the demand falls, you do not reduce the price instead, you stay there because the perceived cost to changing prices outweighs the benefit of the price cut.

Such cost is called Menu-cost because in restaurants, when the price changes they print new menu.

If the menu-costs are higher, the price stickiness will also be higher. It also has managerial costs². Managerial costs are also very critical, because that let’s you to know the logic for the change in price.

Efficiency Wage model

$$e\to \left({\frac{w}{p}}_{+}\right)$$

Efficiency wage model, where the wage is based on the efficiency of the workers and efficiency of the worker in turn depends positively on the real wage they are paid.

The real wage is said to maximize the efficiency of the labor.

In general, the real wage is greater than the market wage.

Rationale

The three reasons why efficiency wage should be greater than market wage

1. The shirking³ model: By setting the real wage above the market wage, the employee will be more careful.
2. Turn-over cost: By paying more real wage than the market wage, firms can reduce the quit-rates⁴
3. The gift exchange: By paying more real wage than the market wage, the morale of the employees increase.

$$Y=F(k,eN)$$

Insider-Outsider model

Why unemployment persists even after it’s initial cause is long past? This is explained by the insider-outsider model which is based on imperfect competition.

Union members are insiders and the non-union members are outsiders.⁵

Insiders have more bargaining power with employers because it is costly to replace them with outsiders⁶. Thus the insiders have the bargaining power to push the real wage above the market wage. As a result, the firms will not be interested to hire/take the outsiders who were the insiders once-upon a time.⁷

Footnotes

1. Markets don’t clear ↩

2. To do the calculation for the change in price ↩

3. Neglect ↩

4. Attrition rates: how people drop out ↩

5. Insiders are those people who are already working for a company or institutions. ↩

6. Training and recruitment costs etc ↩

7. Don’t forget that the insiders who are already there will demand for higher wage, because of which the firms will ask them insiders to manage with the existing work-force even after recession. ↩