The supply side of RIKMOD: Short-run producer behaviour in a model of monopolistic competition

Abstract

The supply side of RIKMOD — which is a quarterly model of the Norwegian economy — is derived from the short-run decisions of a profit maximizing firm in a monopolistically competitive market. We first derive the levels of price, output and employment which would maximize profit if employment could be adjusted costlessly. This gives actual price, and the optimal level of employment, as functions of factor and foreign prices, capacity utilization and demand shocks. However, the actual level of employment may deviate from the optimal level, due to costs associated with adjusting employment. The sum of these costs and various costs associated with having a non-optimal level of employment are minimized. This procedure gives employment, working hours and inventories as functions of employment and inventory levels in the previous period and the corresponding levels which would have been optimal if employment adjustment were costless. The paper reports empirical results for the manufacturing sectors of the RIKMOD model. The preferred estimated equations — which are made subject to misspecification tests — are in agreement with the theory. Typically, the results reveal a ‘Keynesian” response pattern to demand shocks. ‘Classical” results appear only for relatively high degrees of capacity utilization.