Arnold Kling  

Another Half-Baked Model

Why Are Free Market Economists... Now versus 1973...

This is an attempt to get at the notion of real adjustment costs in a model of Patterns of Sustainable Specialization and Trade. It is something like the Fischer Black model of macro, which influenced Tyler Cowen and me to talk about recalculation.

--two goods, X and Y. Y is used as the price benchmark (numeraire in econ jargon), and its price is $1.

--a small country, or a small segment of the economy, which means that the price of X is given by forces outside of its control.

--each period, a fraction of workers retires and is replaced by the next vintage of workers

--before a new vintage of workers joins the labor market, they have to decide whether to invest in skills to produce X or skills to produce Y. Once you invest in skills, your marginal product in producing the other good is zero.

--there are fixed costs associated with having employees, so that when a firm cuts back it will lay off employees rather than cut back hours.

--there is a non-trivial opportunity cost to workers, so that they have a reservation wage that is greater than zero.

Now, imagine that for a number of periods the price of X has been $1.20 Naturally, existing workers have invested in skills to produce X, the country is basically specialized in producing X, and it trades X for Y in the world market.

Next, suppose that the terms of trade shift, so that the price of X falls to $.80. New vintages of workers will train in Y. However, older workers will find that their skills are worth much less in the world market. Wages fall, but not enough to restore full employment. The workers who are unemployed would rather be working at the going wage, but the fixed cost of labor means that they are laid off rather than simply reducing hours worked.

Comments and Sharing

COMMENTS (3 to date)
Various writes:

Absolutely. This reminds me of some of my buddies. Some have skills that are somewhat transferable to other fields with minimal to moderate training. Others have skills that are not least not transferable at the wages to which they've become accustomed. Can anyone say "construction worker"?

Lord writes:

People could be retrained but the problem here is the profit went from $0.20 to -$0.20. Even if retrained it would only reach $0. The problem is the exchange rate has become too high. By lowering the exchange rate, the monetary authority can reduce the loss, letting Y reach $1.20 and X $1. This won't eliminate the cost or need to need to change, but will provide the incentive to do so by allowing current production to continue though without profit but allow switching to restore profitability. That is really what the central bank does, set the overall profitability of the economy.

jsalvatier writes:

Much better than your last story. It's important to point out that such stories aren't really mutually exclusive with monetary stories.

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