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.