Real Rigidities in the Goods Market
The most important factor associated with real rigidity in the goods market is the existence of imperfect competition. Imperfect competition enables producers to be price-setters and generates rigidity in real prices in relation to quantities.
Under imperfect competition price is set, not equal to marginal cost, but as a mark-up over cost. The mark-up covers fixed costs of production including profits. One of the important propositions of the New Keynesian economics is that the mark-up behaves in a counter cyclical fashion, i.e., it decreases during booms and increases over the downward phase of a business cycle. It is these countercyclical movements of the mark-up that produce rigidity in prices of goods. An increase in aggregate demand translates, not into an increase in prices, but into an increase in quantities of goods produced, and thereby of employment.
Why do mark-ups behave in a countercyclical manner? Several reasons have been postulated:
i) Higher level of economic activity during booms reduces the importance of costs of acquiring and disseminating information and thus makes markets more competitive. This has been referred to in the literature as "thick- market" effects. -
ii) It has been suggested that increased profits created by greater economic activity make it difficult for oligopolists to maintain collusion - incentives are generated to break away from oligopolistic structures. This puts downward pressures on mark-ups.
iii) It has also been suggested that mark-up is countercyclical because marginal costs are pro-cyclical. Marginal costs are considered to be pro-cyclical because overtime paid to workers is highly pro-cyclical and hence expensive to firms. This, however, begs the question about why prices are rigid in the goods market. The argument here seems to be that, because prices are rigid, .the mark-up is compressed as marginal costs rise. We have been attempting to explain the rigidity of prices by postulating that mark-ups fall over booms in spite of costs rising (and not because of increase in costs) for reasons independent of the rise in costs. When price rigidities exist in imperfectly competitive goods markets, the impact of increase (decrease) in aggregate demand is borne by quantities leading to an increase (decrease) in aggregate output and employment.