Economics · Ch 4 — Determination of Income and Employment
Determination of Equilibrium Income in the Short Run
Determination of Equilibrium Income in the Short Run
The Two-Step Approach to Macroeconomic Equilibrium
In microeconomics, when you study a single market, the demand and supply curves intersect to determine both the equilibrium price and the equilibrium quantity simultaneously. Macroeconomics, when dealing with the whole economy, does not do this in one step. Instead, it follows a deliberate two-stage process.
Stage 1: The price level is taken as fixed. We work out the equilibrium level of income and output assuming prices do not change.
Stage 2: Only after this is understood do we allow the price level to vary and re-analyse the equilibrium.
Why fix the price level at the first stage? There are two clear justifications.
Why the Price Level is Held Fixed
1. The Economy Has Unused Resources
The first reason is the most important for understanding the short run. We are assuming an economy that is operating below its full capacity. There are idle factories, unused machinery, and unemployed labour. In such a situation, the law of diminishing returns does not apply. Why? Because a firm can put more workers to work on already-existing machines without running into bottlenecks. It can increase production without its marginal cost rising.
If marginal cost does not rise, firms have no reason to raise their prices when they produce more. The price level, therefore, remains constant even when the total quantity of output changes. This is a realistic description of a recession or a slump.
2. A Simplifying Assumption
The second reason is purely methodological. This is a simplifying assumption that makes the initial analysis tractable. It is a deliberate choice to isolate the effect of changes in aggregate demand on output, without the complication of changing prices. The textbook explicitly states that this assumption will be relaxed later (in later chapters or sections), when the analysis moves to the medium run or the long run.
Do not confuse this fixed-price assumption with the idea that prices never change in the real world. It is a deliberate modelling choice for the short run, justified by the presence of unemployed resources. In the long run, or when the economy is at full employment, this assumption is dropped.