This paper presents a theory of rigidity, or more properly inertia, in the responses of economic variables to changing environments. The theory rests on three fundamental assumptions: (1) that firms are risk averse, (2) that firms are uncertain of the impacts of changing decision variables and (3) that this uncertainty increases with the size of deviations in decision variables from appropriately defined past level. Under these circumstances an optimal portfolio of incremental decision variable adjustments exists which (a) takes variance minimizing adoptions to environmental change as a point of departure and then (b) is weighted in favor of changes in variables whose effects are less uncertain. In considering price and quantity adjustments, this implies that price and wage adjustments should largely incorporate expected inflation and, from that point, should be small relative to quantity adjustments, since in most situations the uncertainties associated with the consequences of quantity adjustment should be smaller than those associated with price adjustments.
*Published:
The American Economic Review, Vol. 79, No. 2, pp. 364-369, (May 1989).
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