Brookings Papers on Economic Activity, 1: 1988 the recession between reduced sales and a lower price. The recession would end and everyone would be much better off if all firms adjusted But each firm believes that it cannot end the recession and therefore may fail to adjust even if the costs of adjustment are much smaller than the costs of the recession This argument resembles standard microeconomic analyses of exter- nalities. Consider the classic example of pollution. Pollution would be greatly reduced, and social welfare greatly improved, if each person incurred the small cost of walking to the trash can at the end of the block But each individual ignores this when he throws his wrapper on the street because he is only one of many polluters. Because of externalities economists do not find highly inefficient levels of pollution puzzling even though the costs of reducing pollution are small. For similar reasons highly inefficient nominal rigidities are not a mystery even though menu costs are sma Externalities from Fluctuations in Demand. Keynesians believe not only that shocks to nominal aggregate demand cause large fluctuations in output and welfare, but also that these fluctuations are inefficient, and thus that stabilization of demand is desirable. The models surveyed so far do not provide a foundation for this view. As explained above, nonadjustment of prices to a fall in demand leads to large reductions output and welfare. But nonadjustment to a rise in demand leads to higher output and, because output is initially too low under imperfect competition, to higher welfare. Thus the implications of fluctuations for average welfare, and hence the desirability of reducing fluctuations, are unclear. Indeed. Ball and romer show that the first-order welfare effects of fluctuations average to zero, which means that the first order-second order distinction is irrelevant to this issue. 8 Nonetheless, Ball and Romer show, by comparing the average social and private costs of nominal rigidity, that small nominal frictions are sufficient for large reductions in average welfare. The private cost is fluctuations of a firms relative price around the profit-maximizing level The social cost is the private cost plus the cost of fluctuations in real aggregate demand Greater flexibility would stabilize real demand, but each firm ignores its effect on the variance of demand, just as it ignores its effect on the level of demand after a given shock. Although both the 8. Ball and Romer, ""Are Prices Too Sticky?