Chapter 12: Problem 6

Does neoclassical economics view prices and wages as sticky or flexible? Why?

Short Answer

Expert verified

Neoclassical economics views prices and wages as flexible, based on the principles of Say's Law, the Invisible Hand, and rational behavior by individuals and firms. Prices and wages adjust according to market supply and demand, ensuring efficient allocation of resources and equilibrium in both the goods and labor markets. As prices and wages change in response to market imbalances, the market naturally moves back toward equilibrium.

Step by step solution

Understand Neoclassical Economics

Neoclassical economics is a school of thought that believes in the efficiency of markets, rational behavior of individuals, and a focus on the long run equilibrium. It relies on the assumption that individuals and firms act rationally to optimize their utility and profits, respectively.

Neoclassical View on Prices and Wages

Neoclassical economics generally views prices and wages as flexible. Price flexibility is a significant cornerstone of neoclassical economics because it enables markets to function efficiently. Prices act as signals in the market to allocate resources efficiently, and any deviation from the equilibrium will lead to price adjustments, which in turn brings the market back to the equilibrium.

The Reason Behind Price Flexibility in Neoclassical Economics

The belief in price flexibility in neoclassical economics arises from two core principles: Say's Law and the Invisible Hand. Say's Law states that supply creates its own demand, which implies that producers would adjust their prices to clear their inventories if the market experiences short-term imbalances. On the other hand, the concept of the Invisible Hand, proposed by Adam Smith, emphasizes that when individuals and firms act in their own rational self-interest, the market tends to allocate resources efficiently, ultimately leading to an equilibrium where prices are flexible.

Neoclassical View on Wage Flexibility

As for wages, neoclassical economics assumes that they are also flexible. Wages adjust to reflect the supply and demand for labor in the market, thus ensuring that labor markets clear. Any disequilibrium in the labor market will lead to changes in wages, which will bring the labor market back to the equilibrium.

The Reason Behind Wage Flexibility in Neoclassical Economics

The idea of wage flexibility in neoclassical economics comes from the assumption of rational behavior by individuals and firms. Workers are assumed to maximize their utility by choosing the best wage and employment offer available to them, while firms try to maximize their profits by paying wages that reflect the productivity of their workers. Therefore, any imbalance in the labor market will lead to adjustments in the wages offered and accepted, thus bringing the market back to the equilibrium.