Mesoeconomics: A Micro-Macroeconomic Analysis

Mesoeconomics: A Micro-Macroeconomic Analysis

There are a number of different approaches of economic analysis described as mesoeconomics. (See under ‘mesoeconomics’ in .) This entry is confined to the method of micro-macro analysis based on a representative firm that is not necessarily perfectly competitive. It uses the microeconomic mechanism at the firm level to analyze variables like the price level and aggregate output at the economy level or at the industrial level. The method was developed by Yew-Kwang Ng of Monash University, Australia with papers initially published in Australian Economic Papers 1977 and Economic Journal 1980, but in more mature form in Economica 1982. A full analysis is contained in his monograph Mesoeconomics: A Micro-Macroeconomic Analysis, 1986. Later extensions include his American Economic Review 1992 paper and papers by Abayasiri-Silva and Shi in the same issue and his joint paper with Wu in 2004.

This method of economic analysis is based on the idea that, most output and pricing decisions in a modern economy are taken by business firms. The price level of an economy is just the (quantity-weighted) average of prices of all firms and the aggregate output is just the (price-weighted) sum of the output levels of all firms. Thus, the pricing and output decisions of an appropriately defined representative firm may represent those of the whole economy in terms of the price level and aggregate output. To justify the methodological validity of this approach, Ng (1986, Appendix 3I) uses a traditional fully general equilibrium analysis (without any of the simplifications used in the mesoeconomic method; these simplications allow analysis leading to many results despite the generalization to non-perfect competition) to show that (1) for any (exogenous) change (in cost or demand) there exists, in a hypothetical sense, a representative firm whose response to the change accurately (no approximation needed) represents the response of the whole economy in aggregate output and average price, and (2) a representative firm defined by a simple method (that of a weighted average) can be used as a good approximation of the response of the whole economy to any economy-wide change in demand and/or costs that does not result in drastic inter-firm changes. This vigorous demonstration provides a solid methodological foundation for mesoeconomics.

Mesoeconomics concentrates on the microeconomics of profit maximization by a representative firm but takes account of the influence of macro variables like the price level, aggregate income/output level, and interactions with other firms on the demand and cost functions of the representative firm. It is called mesoeconomics as it synthesizes micro, macro and general equilibrium analysis. It provides many comparative-static results, including the Keynesian and the Monetarist results on the effects of a change of nominal aggregate demand as special cases. In other words, an increase (the reverse applies for a decrease) in nominal aggregate demand (such as might be triggered by an increase in money supply or increases in consumer and/or investor confidence) may lead to an increase in the price level only with no effect on real variables (the Monetarist case), or it may lead to an increase in the employment and output levels only with no effect on prices (the Keynesian case), or a mixture of the two (the intermediate case). In fact, more extreme cases of an expectation wonderland and cumulative expansion/contraction may also be possible. Under the Expectation Wonderland, what will happen depends entirely on the price expectation of firms. If firms expect the price level to increase with no change in output, that will be realized. If firms expect the output level to increase with no change in prices, that will also be realized. It then becomes rational to expect whatever that is expected to be expected! This may provides a micro foundation for the so-called sunspot equilibria or multiple or even a continuum of equilibria which may partly explain business cycles, the importance of business confidence, and the difficulties of economic prediction (Ng 1980, 1986, 1992, 1998, 1999). The case of cumulative expansion/contraction is more Keynesian than the Keynesian case; an increase in nominal aggregate demand leads to an increase in output and a fall in prices, leading to further cumulative increases in output and further falls in prices.

It is interesting to note that, under normal conditions, once it is assumed that firms are perfectly competitive, the Monetarist case must apply. With not necessarily perfectly competitive firms (perfect competition, monopolistic competition, oligopoly, monopoly are all allowed), all the cases discussed above are possible. Even in the absence of time lags, money illusion, and other frictions, just the relaxation of perfect competition may make a change in nominal aggregate demand affect either the price level (the monetarist case) or the real output (the Keynesian case). The crux of the difference may be briefly seen. It is two sided. On the demand side, with a horizontal demand curve under perfect competition, the curve cannot shift left or right. It can only shift up or down. But an upward shift means an increase in price. In the absence of money illusion, time lags, etc, an increase in prices also increases costs proportionately, leading to the absence of any real changes. (The demand curve and the marginal-cost curve of the firm both shift upward by the same extent, with the profit-maximization intersection point occurring at the same output level. This is the simple micro foundation for the Monetarist or neutrality-of-money result under perfect competition.) In contrast, under non-perfect competition, the demand curve is downward-sloping and it may shift either upward/downward or rightward/leftward, allowing for possible real effects of a change in nominal aggregate demand.

On the supply side, a profit-maximization equilibrium with a horizontal demand curve implies an upward-sloping MC (marginal cost) curve. This makes an expansion in output associated with a higher MC which calls for a higher price. But a higher price is contractionary as it decreases real aggregate demand at a given level of nominal aggregate demand. In contrast, for the case of non-perfect competition, the MC curve may be horizontal or even downward sloping. The decrease in MC with a higher output, if not more than offset by an upward shift in the MC curve as aggregate output expands, may make higher output levels possible equilibria. (The full analysis takes into account consistency with the general-equilibrium effects of infinite rounds of feedback between a firm and the rest of the economy, including the effects on its cost and demand functions.)

In the non-traditional cases (other than the Monetarist case), there exists an interfirm macroeconomic externality where the expansion by each firm benefits other firms apart from the familiar income multiplier effects. This is an area where welfare economics, macroeconomics and its micro-foundation intersect, an area still not adequately studied.

The effects on the price level and aggregate output depends on the exogenous changes in demand and costs as well as the endogenous response variables, including the slope of the MC curve (of the representative firm), how much MC responds to aggregate output and the price level (shifts in the MC curve), how much the price elasticity of demand changes in response to real aggregate demand, how much the nominal aggregate demand changes in response to real aggregate income and the price level. An estimate of these changes and responses would then give us estimates of the effects of exogenous changes on the price level and aggregate output using the respective equations provided in the mesoeconomic publications listed in the references below. For the long-run case, the degree of competition, the entry effect, and the responses of average cost to aggregate output and the price level are also relevant.

The basic analysis has been extended in a number of ways, including:
1. The introduction of a government sector, with the results that the balance-budget multiplier is negative. However, for cases close to the Keynesian, a tax reduction may be self-financing.
2. Allowing for profit-constrained revenue maximization and other forms of average-cost pricing makes the non-traditional cases more likely to apply as average-cost curves are more likely to be downward sloping than marginal-cost curves.
3. Analyzing an industry instead of an economy, with results such as: industrial-wide taxes and cost increases are likely to be more than 100% passed on to consumers; an increase in demand may decrease the industrial output.
4. Explaining why mark-up pricing is prevalent.

References

ABAYASIRI-SILVA, K. (1992). Aggregate supply functions in closed and open economies: A mesoeconomic analysis, American Economic Review, 82(2): 379-385.
DIXON, Huw & RANKIN, Neil (1994). Imperfect competition and macroeconomics: a survey. Oxford Economic Papers, 46: 171-199.
NG, Yew-Kwang (1982), A micro-macroeconomics analysis based on a representative firm, Economica, 1982, 49: 121-139.
NG, Yew-Kwang (1986), Mesoeconomics: A Micro-Macro Analysis, London: Harvester, 1986.
NG, Yew-Kwang (1992), Business confidence and depression prevention: A mesoeconomic perspective, American Economic Review, 82(2): 365-371.
NG, Yew-Kwang (1998), Non-neutrality of money under non-perfect competition: why do economists fail to see the possibility? In K.J. Arrow, Ng, and Yang, eds., Increasing Returns and Economic Analysis, London: Macmillan, pp.232-252.
NG, Yew-Kwang (1999), On estimating the effects of events like the Asian financial crisis: A mesoeconomic approach, Taiwan Economic Review, 27 (4): 393-412.
NG, Yew-Kwang and WU, Ying (2004), Multiple equilibria and interfirm macro-externality: An analysis of sluggish real adjustments, Annals of Economics and Finance, 5: 61-77.
SHI, He-Ling (1992), Continuum of equilibria and business cycles: A dynamic model of mesoeconomics, American Economic Review, 82(2): 372-378.

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