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5.3.2 Continuous market clearing

A second key assumption in new classical models is that all markets in the

economy continuously clear, in line with the Walrasian tradition. At each

point of time all observed outcomes are viewed as ‘market-clearing’, and are

the result of the optimal demand and supply responses of economic agents to

their perceptions of prices. As a result the economy is viewed as being in a

continuous state of (short- and long-run) equilibrium. New classical models

are in consequence often referred to as ‘equilibrium’ models, where equilibrium

is interpreted to mean that all economic agents within a market economy

have made choices that optimize their objectives subject to the constraints

that they face.

In market-clearing models economic agents (workers, consumers and firms)

are ‘price takers’; that is, they take the market price as given and have no

market power that could be used to influence price. Firms are operating

within a market structure known as ‘perfect competition’. In such a market

structure firms can only decide on their optimal (profit-maximizing) output

(determined where marginal revenue = marginal cost) given the marketdetermined

price. In the absence of externalities the competitive equilibrium,

with market prices determined by the forces of demand and supply, is Paretooptimal

and leads to the maximization of total surplus (the sum of producer

and consumer surplus). In Figure 5.2(a) we can see that a competitive

market-clearing equilibrium (P*, Q*) maximizes the total of consumer and

producer surplus (equal to area BCE) whereas non-market-clearing prices

(output), such as P1(Q1) or P2 (Q2 ), indicated in Figure 5.2(b), result in a

welfare loss indicated by the areas FEI and GEH respectively (see Dixon,

1997).

In Figure 5.2(a) all the mutual gains from trade have been exhausted by

economic agents and there are ‘no dollar bills left on the sidewalk’ (see

Barro, 1979). It is important to note that the position of supply and demand

curves, and hence market-clearing prices and equilibrium output, will be

influenced by the expectations of economic agents. Since even rationally

Figure 5.2 The welfare implications of equilibrium in a competitive market

Consumer

surplus

A

B

S

D

Q*

P*

Producer

surplus

(a) Competitive equilibrium

A

B

S

D

Q*

P*

(b) Welfare loss if output is

above or below the

competitive price

C

E

C

G

E

F

H

P1

P2

Q2 Q1

I

formed expectations can turn out to be wrong due to incomplete information,

this means that, at least until agents acquire more accurate information, a

currently observed market-clearing equilibrium will differ from a full information

equilibrium. Nevertheless, since agents are doing the best they can

with the information they have acquired, they are seen to be in a state of

equilibrium at all times, as illustrated below.

RATIONALITY OPTIMIZATION EQUILIBRIUM

The assumption of continuous market clearing is the most critical and controversial

assumption underlying new classical analysis and is highly contentious,

as it implies that prices are free to adjust instantaneously to clear markets (see

Tobin, 1993, 1996). The assumption stands in bold contrast to the approach

adopted in both orthodox Keynesian and monetarist models. As we have

discussed in the two previous chapters, orthodox Keynesians and monetarists

disagree about the time it takes for markets to clear. Keynesian models

incorporate the assumption that markets may fail to clear because of the slow

adjustment of prices, so that the economy is viewed as being in a possible

state of continuous disequilibrium. In contrast, orthodox monetarist models

incorporate the assumption that prices adjust fairly rapidly to clear markets

and, while accepting that the economy may be in disequilibrium in the short

run, monetarists assume that the economy will automatically return to a state

of macroeconomic equilibrium in the long run at the natural rate of output

and employment.

The assumption of continuous market clearing is far more controversial

than the rational expectations hypothesis. As we shall discuss in Chapter 7,

new Keynesians have put forward a number of arguments to explain why

both prices and wages will be slow to adjust to clear markets following a

disturbance. Serious objections can be raised as to the reality of the new

classical assumption, especially with respect to the labour market, where new

classicists hold that anyone wishing to work can find employment at the

market-clearing equilibrium wage; that is, the new classical equilibrium approach

treats unemployment entirely as a voluntary phenomenon (Lucas,

1978a). However, given efficiency wage considerations (see Chapter 7) it can

be argued that it is both profitable and rational for a firm to pay an efficiency

wage above the market-clearing wage. In such a situation equilibrium in the

labour market can occur where supply exceeds demand, with the existence of

involuntary unemployment as an equilibrium phenomenon.

We now consider the final main tenet of new classical macroeconomics,

the aggregate supply hypothesis.