Knightian Uncertainty, General Equilibrium Theory and Macroeconomics

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The behavior of labor markets seems extremely puzzling from the point of view of economic theory and especially the theory of competitive equilibrium. Perhaps the biggest puzzle is the insensitivity of wages to the unemployment rate. High unemployment should represent an excess supply of labor, yet the unemployed do not seem to bid down wages very effectively. If labor markets acted like truly competitive markets, then wages should plunge in the face of high unemployment, just as stock and commodity markets sometimes do. Yet wage cuts in recessions seem to be moderate and infrequent. Another puzzle is that wages do not always respond immediately and completely to changes in the consumer price index, whereas most theories of wages determine real, not nominal wages. A third puzzle is the occurrence of strikes. Strikes seem to cause an unnecessary loss to both employer and employees, since it should be possible to anticipate the consequences of a strike and reach an agreement without one. The thesis of this project is that these and other puzzles in economics can be best explained by a new theory of decision making under uncertainty that captures the instability or fragility of expectations. This grant also supports theoretical research on general equilibrium models which express macroeconomic phenomena. The distinctive feature of these models is that firms are able to compete effectively only in the long-run; in the short-run firms have difficulty invading each others markets. This difficulty would make firms have a low short-run elasticity of demand for labor. The rivalry among firms would be expressed by a non- cooperative equilibrium. The conditions under which such an equilibrium will exist are rigorously defined. Unemployment is shown to exist and fluctuate. The determinants of the average growth rate of the economy are analyzed and shown to offer a plausible explanation of the wide variation of growth rates among countries. The welfare losses resulting from unemployment and from the monopoly power of businesses are estimated. The project compares the costs and benefits of wage controls within such a theoretical framework. The project also analyzes government policies controlling inflation.