The case for a new theory of how markets really work
A new framework shows how uncertainty and real world constraints break traditional models and offers a more realistic theory of pricing inflation and productivity.
Most students of economics are introduced to the "invisible hand," the idea that businesses set prices to balance supply and demand. However, new research from Yale’s Joel P. Flynn and co-authors George Nikolakoudis and Karthik A. Sastry challenges this standard view.
In the real world, it is rare that markets “clear”—meaning that all the products reach customers thanks to the balancing of the invisible hand. Businesses must often commit to what they will charge and how much they will produce before they know what the actual demand will look like.
A Model for the Service Economy
While traditional economic theories were built in an era of manufacturing, this research is particularly descriptive of the modern service industry, which now dominates the U.S. economy.
In this simple model, unsold production has no value to the firm. For services, this is a reasonable assumption: if a hairdresser sits in the salon and nobody shows up, there is no way to recoup the lost time. Moreover, for perishable goods, such as food, a similar principle applies.
When it comes to services, output cannot be stored in a warehouse. Consider a restaurant or a law firm. If there is little demand, like at a bar on a Tuesday at noon, employees sit idle and that time is lost forever. On the other hand, if demand exceeds the staff’s capacity, customers are turned away or forced to wait.
Because service providers cannot use inventory to smooth out these fluctuations, they face a constant risk of paying for idle staff or losing sales because they are understaffed. To protect themselves, firms “shrink” themselves by raising prices and reducing hiring to ensure that the revenue from the customers they do serve covers the cost of the hours their staff might spend waiting for work.
New Old Keynesians
The authors call their framework the “New Old Keynesian” (NOK) model because it bridges two distinct eras of economic thought to fix a long-standing logical gap.
The “Old” Keynesian element refers to a 1970s concept known as disequilibrium which rejects the idea that markets always clear. The “New” Keynesian element draws from modern macroeconomics. The model utilizes “sticky” decisions—where only a fraction of firms can adjust prices or production at any given time—and relies on rational expectations, which assumes that individuals make their best possible guesses about the future.
By combining these, the NOK model represents a fundamental departure from standard economic theories. Traditional New Keynesian models often make an implausible assumption: that firms hire whatever labor is necessary to meet demand, even if it is unprofitable. The NOK model restores the core principle of voluntary exchange—firms rationally choose both their prices and their labor inputs to maximize profits under uncertainty.
The Macro Consequences
One of the most striking findings of this research is that uncertainty has first order effects on the economy. In standard models, business uncertainty is generally ignored. In the NOK model, however, uncertainty alone can trigger inflation through the business shrinking effect.
Then there is the surprising impact on productivity. When businesses feel uncertain, they raise prices. These high prices discourage consumers, causing goods and services that have already been produced to sit idle. The economy appears less productive simply because uncertainty has broken the mechanism that guides consumers to the available supply.