On the Microeconomics of ‘Stagflation’1

• Published date: 01 September 1971
• DOI: http://doi.org/10.1111/j.1813-6982.1971.tb00290.x
• Author: M. L. TRUU
• Date: 01 September 1971

On the Microeconomics of "Stagflation"*(1)

by M. L. TRUU

I

DURING THE 1970 midterm election campaign in the United States, the President's political enemies coined the term "Nixonomics"

to denote an economic state in which the things that ought to go up (the stock market, company profits, real disposable income,

productivity) actually go down, while those that should go down (unemployment, prices, interest rates) go up. It appeared in due

course that this perplexing state of affairs was by no means confined to the United States, and the phenomenon of concurrently

rising unemployment ("stagnation") and prices ("inflation") came to be known as "stagflation" in the world of journalism and also

beyond it. While this recent experience has therefore been considered sufficiently novel to warrant the creation of yet another

ingenious neologism, it would at the same time appear to lend itself to ready explanation by means of certain basic concepts

belonging to traditional price theory.

The relevant model is that which describes "domination", "exploitation" or "first-degree price discrimination" under bilateral

monopoly, more specifically, where the monopolist extracts from the monopsonist a price which just enables the latter to break

even in terms of revenue and cost.*(2)

For reasons of convenience, it will be assumed here that the relevant production function is characterised by factor

complementarity rather than substitution. The extreme case of factor complementarity would be represented by the availability of a

single process in the production of a specific output. That is, irrespective of the level of output, the required inputs (say, labour

and capital) should always be employed in a fixed ratio. The assumption of factor substitutability would not invalidate the

conclusions of the model; the same destination would still be reached, but along a somewhat more devious route.

Figure 1 shows the situation of a producing firm in the market for a particular input, say labour, where the demand for labour is

represented by its marginal revenue product (MRP) schedule. If factor input equals ON, the ruling wage rate (the firm's average

cost) is OV, with a corresponding average revenue product OW. VW thus represents the surplus per unit which results from the

employment of ON factor units. If this information is also known to the labour union concerned, it

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FIG. I : INPUT MARKET

FIG. 2 : OUTPUT MARKET

1971 SAJE v39(3) p263

may now insist on a higher wage rate, backing its demand by the threat of strike if necessary. The maximum wage rate which the

firm could pay under existing circumstances is OW, where the average cost of ON workers is equal to their average revenue

product. The firm would in turn counter this attempted "exploitation" by reducing its employment of labour at wage rate OW from

ON to OM, where average revenue product exceeds average cost by WZ. Total profit resulting from the employment of the factor

thus falls by (VW x ON) - (WZ x OM).

This situation is reflected in the market for the firm's final output, shown in Figure 2, where OM units of labour, combined with a

given amount of capital, have been transformed into oa units of final output. Given the demand (or average revenue) schedule ar,

the product is then sold at a unit price os. The average cost schedule acv corresponds to wage rate OV, thus leaving a profit

margin of kl. As the wage rate rises to OW, the average cost schedule accordingly rises to acw. The remaining profit margin ml

would be entirely due to the employment of the complementary factor, capital. The reduction in labour input by NW, coupled with a

corresponding reduction in capital input, causes output to contract from oa to ob, thus yielding a higher unit price, ot. The overall

profit margin nr is the joint outcome of a reduced margin on the labour employed (WZ in Figure 1) and an increased margin on

capital.

The final result is therefore characterised by a lower level of employment of both labour and capital as well as smaller volume of

final output at an increased price level, that is, "stagflation".

A necessary condition for this particular outcome is, of course, that the demand schedule for final output (ar in Figure 2) should

remain fixed in its initial position. Is this condition likely to be satisfied? If the customers of the firm are assumed to be its own

employees and shareholders, then their disposable incomes have declined in both cases: wages by (OV x ON) - (OW x OM) and

profits (= dividends) by (kl x oa) - (nr x ob). Consequently it is necessary that other things should not remain equal if the demand

schedule in Figure 2 is not to shift to the left. Thus, expenditure by unemployed workers may now be financed from union or other

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