A Simple Analysis of Price and Output Determination: A Model with Imperfect Competition

The core of any basic course in macroeconomics is the development of a set of instruments for the determination of the level of output, the aggregate level of price, the rate of unemployment and the rate of inflation. As far as output and price are concerned, most macroeconomic textbooks end up suggesting that the many economic forces which lie behind their determination can be described within a demand-supply scheme. This choice is probably justified both by the desire to use intuitive and familiar instruments, and by the simplicity of the reference framework. The idea is that domestic output is a composite good, the demand for which depends negatively on its price, due to a real-balance effect as well as, in open economies, a terms-of-trade effect. Supply of domestic output may or may not depend on this price, depending on whether changes in the price level affect the agents behaviour in the labour market. The supply curve is vertical if the nominal wage adjusts istantaneously to any change in price; it is however positively sloped if the nominal wage is fixed; and finally, it is horizontal if the nominal wage is fixed and technology entails constant returns to labour (or price is historically given). In any case, as for peas or oranges, the intersection between demand and supply determines the equilibrium values of output and price.