Worth: Mankiw Economics 5e 354 PART IV Business Cycle Theory: The Economy in the Short Run without formal agreements, firms may hold prices steady in order not to annoy heir regular customers with frequent price changes. Some prices are sticky be cause of the way markets are structured: once a firm has printed and distributed its catalog or price list, it is costly to alter prices. To see how sticky prices can help explain an upward-sloping aggregate supply urve, we first consider the pricing decisions of individual firms and then add to- gether the decisions of many firms to explain the behavior of the economy as a whole. Notice that this model encourages us to depart from the assumption of perfect competition, which we have used since Chapter 3. Perfectly competitive firms are price takers rather than price setters. If we want to consider how firms set prices, it is natural to assume that these firms have at least some monopoly control over the prices they charge. Consider the pricing decision facing a typical firm. The firms desired price p depends on two macroeconomic variables The overall level of prices P. A higher price level implies that the firms costs are higher. Hence, the higher the overall price level, the more the firm would like to charge for its product. The level of aggregate income Y. A higher level of income raises the de- mand for the firms product. Because marginal cost increases at higher levels f production, the greater the demand, the higher the firms desired price We write the firm's desired price as p=P+a(r-r This equation says that the desired price p depends on the overall level of prices P and on the level of aggregate output relative to the natural rate Y-Y. The pa- rameter a(which is greater than zero) measures how much the firms desired price responds to the level of aggregate output low assume that there are two types of firms. Some have flexible prices: they always set their prices according to this equation. Others have sticky prices: they announce their prices in advance based on what they expect economic condi- tions to be. Firms with sticky prices set prices according to pe +a(y-y where, as before, a superscript"e"represents the expected value of a variable. For simplicity, assume that these firms expect output to be at its natural rate, so that he last term, a(r-y), is zero. Then these firms set the price That is, firms with sticky prices set their prices based on what they expect othe firms to chars 4 Mathematical note: The firm cares most about its relative price, which is the ratio of its nominal price level, then this equation states that the desired relative price depends on the deviation of out- User JoENA: Job EFFo1429: 6264_ch13: Pg 354: 27761#/eps at 100s Mon,Feb18,200212:56User JOEWA:Job EFF01429:6264_ch13:Pg 354:27761#/eps at 100% *27761* Mon, Feb 18, 2002 12:56 AM without formal agreements, firms may hold prices steady in order not to annoy their regular customers with frequent price changes. Some prices are sticky be￾cause of the way markets are structured: once a firm has printed and distributed its catalog or price list, it is costly to alter prices. To see how sticky prices can help explain an upward-sloping aggregate supply curve, we first consider the pricing decisions of individual firms and then add to￾gether the decisions of many firms to explain the behavior of the economy as a whole. Notice that this model encourages us to depart from the assumption of perfect competition, which we have used since Chapter 3. Perfectly competitive firms are price takers rather than price setters. If we want to consider how firms set prices, it is natural to assume that these firms have at least some monopoly control over the prices they charge. Consider the pricing decision facing a typical firm.The firm’s desired price p depends on two macroeconomic variables: ➤ The overall level of prices P. A higher price level implies that the firm’s costs are higher. Hence, the higher the overall price level, the more the firm would like to charge for its product. ➤ The level of aggregate income Y. A higher level of income raises the de￾mand for the firm’s product. Because marginal cost increases at higher levels of production, the greater the demand, the higher the firm’s desired price. We write the firm’s desired price as p = P + a(Y −Y −). This equation says that the desired price p depends on the overall level of prices P and on the level of aggregate output relative to the natural rate Y −Y −.The pa￾rameter a (which is greater than zero) measures how much the firm’s desired price responds to the level of aggregate output.4 Now assume that there are two types of firms. Some have flexible prices: they always set their prices according to this equation. Others have sticky prices: they announce their prices in advance based on what they expect economic condi￾tions to be. Firms with sticky prices set prices according to p = Pe + a(Ye −Y −e ), where, as before, a superscript “e’’ represents the expected value of a variable. For simplicity, assume that these firms expect output to be at its natural rate, so that the last term, a(Ye −Y −e ), is zero.Then these firms set the price p = Pe . That is, firms with sticky prices set their prices based on what they expect other firms to charge. 354 | PART IV Business Cycle Theory: The Economy in the Short Run 4 Mathematical note: The firm cares most about its relative price, which is the ratio of its nominal price to the overall price level. If we interpret p and P as the logarithms of the firm’s price and the price level, then this equation states that the desired relative price depends on the deviation of out￾put from the natural rate