Bayesian

Macroeconomic Models with Quantity Rationing
Author(s): John Muellbauer and Richard Portes

Source: The Economic Journal, Vol. 88, No. 352 (Dec., 1978), pp. 788-821
Published by: Wiley on behalf of the Royal Economic Society
Stable URL: http://www.jstor.org/stable/2231979 .
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The EconomicJournal, 88 (DecemberI978), 788-82I

Printedin GreatBritain
MACROECONOMIC
MODELS
RATIONING*
QUANTITY
WITH
I. INTRODUCTION
Our objective here is to clarify the structure and behaviour of a simple macroeconomic model with rationing, emphasising the interaction between the
markets for goods and labour and the role of quantity signals when markets
do not clear. Many features of the model are common to a wide range of recent
contributions to the growing "disequilibrium macro" literature. The major
novelties here are our explicit treatment of inventories, our "double wedge"
diagrammatic apparatus, and our comparative statics results. The buffer stock
role of inventories gives a valuable insight into the nature of quantity signals
in the goods market. We emphasise the intertemporal character of decisions
and the importance of expectations about future states of markets.
Our plan is as follows: Section 2 gives definitions, assumptions, and a simple
introduction to the basic macro model. Section 3 lays out the micro models of
the household and firm, and Section 4 discusses different types of quantityconstrained macroeconomic equilibria which these generate. Section 5 deals
with comparative statics and dynamic problems. Section 6 suggests some further
extensions.
Even without a market for financial assets, the structure of this class of
models is in some respects more complex than that of IS-LM. If it can be
made equally familiar and easy to manipulate, however, it might be more
likely to serve as an alternative framework. Once the basic principles of the
interaction of markets in non-Walrasian equilibria are understood, one is on
more secure ground when turning to the fascinating but difficult problems
raised by the recent reappraisal of Keynes.
It was this reappraisal, associated initially with Clower (I965) and Leijonhufvud (I968), which began the development of a general equilibrium macroeconomics without market clearing.' Their stress on Keynes's conception of
unemployment as a chronic state, emergence from which is at best slow and
imperfect. reauired the denial of Walras's Law. If the values of excess demands
* We owe to our colleague Bertie Hines our original interest in the reappraisal of Keynes and macroeconomic models with quantity rationing (see Hines, I97I). We have benefited from discussions with
him and with Volker Bohm, Dwight Jaffee, Richard Quandt, and David Winter. The Institute for
International Economic Studies of the University of Stockholm provided Portes with a stimulating
environment and support in September I976 during the writing of a first version of this paper, which
Muellbauer benefited from
arose out of Portes's project supported by SSRC (UK) grant HR 3309/I.
participation in Jacques Dreze's seminars at CORE in Spring I976 and I977. Jean-Pascal Benassy,
John Black, Bill Branson, Angus Deaton, Avinash Dixit, Miles Fleming, John Flemming, Bertie Hines,
Takatoshi Ito, Gerald Kennally, and Lars Svensson offered helpful comments on various versions of
the paper; all are exempt from responsibility for remaining flaws.
1 There are of course further antecedents, aside from Keynes himself. Especially important, midway
in time between Keynes and Clower, are Hansen (I95I), which laid the groundwork for the attack
on Walras's Law, and Patinkin (I956), which analysed the effect on the labour market of excess supply
in the goods market.
[ 788 ]

[DECEMBER
1978]
MODELS
MACROECONOMIC
WITH
789
RATIONING
do sum to zero, so that negative excess demand in one market must have a
counterpart in positive excess demand in some other market, there will be a
tendency for relative price adjustment in the direction of eliminating the excess
supplies and demands. If there is a Walrasian auctioneer who knows all the
"notional" (i.e. determined only by initial endowments and prices) excess
demands and can change the prices accordingly before any transactions are
executed, this adjustment might well take place (with some further strong
assumptions; see Arrow and Hahn, I 97
).
But if there is no tdtonnementon prices and transactions take place at prices

other than those of a Walrasian equilibrium, then in any market where there
is non-zero excess demand, agents on the "long" side will face quantity constraints. An agent who is rationed as a buyer or seller on one market and cannot
transact his notional excess demand there will in general alter his behaviour
on other markets. The resulting effective demands, determined by initial endowments, prices, and perceived quantity constraints, need not satisfy Walras's
Law (see Section 4). In this more realistic world, there may be little tendency
for self-correcting adjustment to general market-clearing equilibrium, even if
there are no institutional price rigidities.'
The Walrasian view of interrelated markets clearing simultaneously rests
heavily on a highly centralised, costless system of processing information and
organising transactions. Decentralised market economies obviously do not work
like this, and consequently markets often do not clear. This is so dominant a
feature of some markets (housing, credit) that empirical work has finally begun
to allow it in the maintained hypothesis (Fair and Jaffee, I972; Laffont and
Garcia, I977; Portes and Winter, 1978), although the econometric problems
are considerable (Goldfeld and Quandt, I975).
The type of model we discuss is often called a "disequilibrium" model, but
we agree with Malinvaud (I 977) that this usage is misleading. "Disequilibrium"
connotes motion, but one of the themes Qf this literature has been that the
motion might be slow, misdirected, or non-existent; and any proper disequilibrium analysis requires dynamics, which we discuss only briefly and
informally. We are in fact dealing with a model of "temporary equilibrium
with quantity rationing ".2 Within the unit period, agents have adjusted their
behaviour, in the light of perceived constraints (which typically include quantity constraints on their transactions), so that their actions are mutually
consistent. Although markets may not clear, the equilibrium is a state of rest.3
Such an equilibrium concept gets us part of the way out of the Walrasian
framework. Although these models are in this sense non-Walrasian, they are
nevertheless most assuredly general equilibrium models. They may have no
1 In a different context, Kornai (1971)
has emphasised the persistence and self-reinforcing character
of "disequilibrium" states.
2 The rationing is normally thought of as "informal rationing" of agents on the long side of the
market.
3 The core is of course an example of an equilibrium concept broader than that of Walrasian competitive equilibrium, but it has not proved as fruitful as had once been hoped (Shubik, I975). Hahn
(1978) suggests a different type of non-Walrasian equilibrium. We follow below the "K-equilibrium"
in Benassy (I975).
Ecs 88
27

THE
790
ECONOMIC
JOURNAL
[DECEMBER
auctioneer, no tdtonnementin prices or recontracting, and non-competitive conditions facing agents - but they do all represent an interrelated system of
markets in which actions are made consistent within the unit period. Their
general equilibrium character may be a corrective to the regrettable tendency
among critics of "neoclassical orthodoxy" to identify general equilibrium with
competitive equilibrium or the specific Arrow-Debreu formalisation and dismiss it as hopelessly unrealistic. Such confusion discredits more justifiable
criticism, while ignoring attempts to adapt the general equilibrium framework
so it can deal with real economies.
A major part of the difficulty of models with quantity rationing is that one
is so accustomed to assuming that markets do clear through price adjustment.
When they do not, one has to juggle different combinations of excess supplies
and demands, and this becomes rather complicated. Our "double wedge"
diagram in Section 4, whose basis is derived in Section 3, makes this juggling
quite simple.
Our intention throughout is to give an analytically manageable macro
model with quantity rationing, which can be used in various ways: for exposition; to analyse standard theoretical macroeconomic propositions (the effects
of parameter changes and poli4ies) in the manner of Malinvaud
(I977)
;1
as
a point of departure for empirically implementable models which will allow

and as a relatively
estimation of interrelated markets in disequilibrium;2
simple background from which the really difficult issues posed by this literature
can be approached.
We have also extended the analysis of Barro and Grossman (I976) and
Malinvaud (I977) by using an intertemporal model of the firm, analogous to
the treatment of the household in the existing literature. Thus firms may carry
over inventories from one period to the next, just as households may holcd
money balances. This makes the analysis of quantity-constrained macro regimes fully symmetrical. Moreover, rather than confining firms and households
to point expectations on future prices and quantity constraints, we allow them
to take an explicit probabilistic (von Neumann-Morgenstern) view. In some
respects, these extensions actually simplify the argument.
2.
DEFINITIONS
AND
ASSUMPTIONS
A market is a trading post at which a non-monetary commodity exchanges for

money at a uniform price. Demand is always expressed as an offer of money
for the commodity and supply as an offer of the commodity for money. We
distinguish between quantities actually traded (purchases and sales) and demands and supplies. Furthermore, we distinguish between notional and effective demand (or supply). An agent's notional demand on a given market is that
which he would express on that market in the absence of any quantity constraints
on his transactions in any other markets. In a Walrasian world of agents
1 See also Dixit (I976) for an example in a related context.
See Portes (2976) for an application to centrally planned economies. Fair (I974) takes some important initial steps towards allowing quantity constraints in a large macro model.
2

I978]
MACROECONOMIC
MODELS
WITH
QUANTITY
RATIONING
79I
maximising utility (profit) subject to given initial endowments (technology)

and prices, and able to transact whatever quantities they choose at those
prices, the notional demands depend only on the initial endowments and prices.
But agents may encounter quantity constraints on their transactions. An
agent's effective demand on a given market is that which he will express on
that market taking account of constraints on his transactions in other markets.'
Of course, if he encounters no such quantity constraints on other markets, his
effective demand will be his notional demand. We therefore distinguish further
between constrained and unconstrained demands: the effective demand will
be the unconstrained (notional) demand if the agent does not encounter constraints in other markets, and it will be the constrained demand if he does.
Notationally, taking for example 1 to represent the quantity of labour services
actually traded, we write effective demand as Id; this will either be unconstrained (notional) demand given by the function Id(. ), or constrained demand,
given by id(.). Whereas the arguments of ld(.) will not include quantity constraints on other markets, those of Id(.) will. If the agent (firm) is not so con-
strained, then id
ld(.);
if he is, then Id
ld(.).2
An equilibrium with quantity rationing must satisfy certain conditions (see

(i) aggregate trades must balance, i.e. the total quantity
Grossman, I97I):
sold must equal the total quantity purchased; (ii) exchange must be voluntary,
so no agent sells more than his effective supply or buys more than his effective
demand; (iii) traders on the short side of a given market realise their effective
demands (or supplies) - thus there are no "frictions", and there cannot be
both rationed buyers and rationed sellers on the same market.3 As Benassy
This definition follows Clower (I965) - the "dual decision hypothesis" - and Barro and Grossman
A slightly different concept is used by Benassy (I975); see Portes (I977) for a comparison.
Dreze (I975) requires that the agent also take into account any quantity constraint in market k itself,
so the Dreze effective demand for good k will not exceed the quantity constraint for that good and so
will not reflect the size of excess demand in that market. At least eventually, the demand expressed
in a given market will clearly be affected by the constraint encountered in that market, depending on
the transactions costs of expressing the demand. Thus one may leave the queue if one estimates the
probability of satisfaction to be low or the wait long - e.g. changes in labour participation rates in
long-term Keynesian unemployment. Both the Clower and Dreze concepts assume that the agent
perceives the rationing scheme in operation as "non-manipulable", so the quantity he can transact
will be unaffected by the size of his demand. Again, in practice one might well overbid if one believes
that rationing is likely (e.g. placing multiple orders or applying simultaneously for several jobs),
within limits imposed by transactions costs and the likelihood of being called on bids for more than
one really wants (with resulting loss of deposits, good will, credibility in subsequent bids, etc.). Benassy
(I977), Grandmont (1977a), and Svensson (I977) discuss these issues. Ideally a definition of effective
demand would both allow agents to react to expected constraints in all markets and measure "true"
unsatisfied demand. Svensson (1977) takes a more realistic approach with stochastic constraints, but
this would obscure the market interaction effects we are emphasising.
2 In an n-market model, effective demand in any one market typically depends on constraints encountered in all others, so an agent's effective demand vector is determined component by component.
Benassy (I975) sets out the details of the agent's maximisation problem.
3 Conditions (ii) and (iii) are very strong. Thus contractual working hours must often violate (ii),
and the coexistence of unemployment and vacancies suggests that (iii) is often unrealistic. Indeed,
Kornai (197I) argues that (ii) and (iii) are among the clearly unjustifiable assumptions of general
equilibrium analysis; and Grandmont (1977b) suggests that an equilibrium with quantity rationing
on quantities). Note
involves a high degree of market organisation (to allow the required tdtonnement
that (ii) does not mean that the constrained demand for a good is always less than or equal to the unconstrained demand. The intuitive notion of "spillovers" suggests that effective demand might exceed
notional demand in a many-good model (see Patinkin, 1956; Grossman, 197I; Kornai, I97I; Svensson,
I977).
1
(I976).
27-2

792
THE
ECONOMIC
JOURNAL
[DECEMBER
(I975) and Malinvaud (I977) stress, these conditions will not determine an
equilibrium uniquely. We require in addition a (typically "informal")
rationing scheme for each market, specifying how the commodity is to be
distributed among those on the long side of the market. Benassy's formulation
is quite general, whereas Malinvaud chooses particular rationing schemes for
concreteness (Grandmont, I977a, surveys this question).
We discuss rationing schemes and aggregation in Section 4. A quantityconstrained equilibrium is a state in which each agent's realised transactions
maximise his objective function (utility, profit, or whatever): they are for the
agent the best he can attain, subject to all constraints facing him. A formal
definition is provided by Benassy (I975). We suppose that agents face given
prices in the unit period, but prices can change between periods; this is the
"fix-price" method (see Grandmont, I977b). At any instant, agents view the
quantity "rations" they face as exogenous parameters.' Thus the consistency
of all agents' transactions in a quantity-constrained equilibrium is achieved
through the adjustment of the quantity "rations" without any price changes.
We deal with a capitalist market economy. There are three types of decisionmakers: households, firms, and the government. The government enters the
model through fixing the volume of real government expenditure, which is a
prior claim on output (the government is never rationed2). Government expenditure is entirely exogenous and is taken to include the fixed investment
demand of the private sector. It is assumed to be unproductive in the short run,
although in the longer run the accumulation of fixed assets will shift the production function.
There are three commodities: money, output (goods), and labour, each
homogeneous. Thus there are two markets. Because production is in reality
specialised, firms do not pay workers in output which they consume, so exchange takes place through money. As Hahn (I977a) stresses, it is not the
presence of money in itself which under-lies the failure of markets to clear in
these models, but rather the impossibility of exchanging labour directly for
consumption goods. Money is fiat money. The stock of money is exogenous,
and its total increment during the period is simply the volume of government
expenditure (including fixed investment) during the period; there is no taxation. The excess demand for money is purely an asset demand, unaffected by
transactions requirements (or interest rate uncertainty, since there is no return
on holding money balances), and the corresponding excess demand function
is therefore best viewed as a savings function (see Section 3). For firms, the
analogous asset is inventories. Firms do accumulate money (undistributed
profits) during the period but pay it all out to households as dividends at the
1 As Arrow (I959)
pointed out, an agent in a market with excess supply or demand must perceive
a demand or supply curve which cannot be unbounded and horizontal, and the fix-price assumption
is dropped in recent papers by Hahn (I978) and Negishi (1976).
2 In reality, of course, the expenditure plans of government and investors may also be partly frustrated if there is excess demand for goods. The simplifying assumption here is not essential, but it
facilitates the analysis of effects of changes in government expenditure and allows us to avoid discussing
its determinants. Even when Fair (1974) introduces goods rationing into his much more complex
model, he confines its impact to the household sector so as to simplify consideration of the labour
supply effect, which is our primary concern here.

I978]
MODELS
MACROECONOMIC
WITH
QUANTITY
RATIONING
793
beginning of the next period. Neither households nor firms may borrow.
Clearly, this simple model will omit many of the interactions between shortand long-run expectations, liquidity preference and investment decisions,
which have been such a major theme in the reappraisal of Keynes (see Leijon-
hufvud, I968; Hines,
I97I).
Labour services are the only variable input. Households supply labour,
demand goods and money balances, and have stable preferences represented
by a utility function which they maximise. They may receive profits, but they
take all non-labour incomes to be exogenous, independent in the slhort run of
labour services sold. Firms demand labour and inventories, supply goods, and
maximise profit or a more general utility function.
We use the following notation:
Yt
Xt
it
Ct
gt
it
Tt- It
mt
Wt
Pt
St
iTt
dt
flow of output (production) per period

sales of goods per period
inventories held at end of period t (beginning of period t + I)
flow of goods purchased by households
flow of goods purchased by government
flow of labour services sold by households
household leisure time
stock of money balances at end of period t (beginning of period t +
money wage rate
price of the good
flow of household savings
profits
dividend payments to households at beginning of period t
I)
Superscripts d and s denote demand and supply, h and f denote households

and firms, and A is the one-period difference operator.
Thus we have the following accounting relationships:
Yt=
Xt =Ct
xt + Ait,
()
+gt)
(2)
St -dt +wtlt-ptct
Tt
=Ptxt-
- Amt,
wt It,
(4)
Amf 7Tt--dt = ptxt-wtlt-d

Pttt
mf=
ptxt-ptct
(3)
Am+Amf,
Irt = dt+?.
(5)
(6)
(7)
The household savings flow (income less consumption) equals the increment
to household money balances. Firms' profits this period (sales less wages) less
dividends (last period's profits) equal the increment to firms' money balances.
Government expenditure equals output less consumption and inventory accumulation, or profits plus savings out of labour income, i.e. the total increment

794
THE
ECONOMIC
JOURNAL
[DECEMBER
to the money balances of the public.' With transfer payments to households

and taxes on firms and households, government expenditure would be financed
by Amplus taxes net of transfers.Note that (i) ignores inventory holding costs,
which are introduced in Section 3.
The fundamental distinguishingcharacteristicof this class of macroeconomic
models is the assumption that on each market, the quantity traded is the
minimumof effective demand and effective supply. Given the assumption that
the government is never rationed on the goods market, the two minimum
in our model can be written
conditions
c = min (Cd,cS),
(8)
(9)
min (l, Is).
The real complications arise because the effective demand and supply in
each market depend on what is happening in the other market. Indeed, because
the functionalform of a quantity-constrained demand differs from that of the
corresponding notional (entirely price-determined) demand, if excess demand or supply appears in one market and either buyers or sellers there become rationed, we must switch from the unconstrained to the constrained
functional form to represent their behaviour on the other market. Thus not
only does effective demand on the goods market depend on the quantity traded
in the labour market: the effective demand function for goods depends on
whether there is excess supply or demand for labour. If there is non-negative
excess demand for labour, then the effective demand for goods is the notional,
unconstrained demand, so the demand function for goods has only prices and
initial assets as arguments: cd-- cd(.). But if there is excess supply of labour,
then we switch to the quantity-constrained effective demand for goods, one
argument of which is the quantity of labour actually sold: cd =d(l;
. ). This
switching between functional forms occurs not only for the demand for goods,
but also for the supply, and for the demand for and supply of labour. The
are indeed the essence of the Clower-Patinkin "dual decision
switchingconditions
hypothesis".
Thus, disregarding the borderline cases of market clearing, we have four
possible constraint regimes (the labels K, R, C and U will be explained in
Section 4):
(K) cd <
cS,
Id < IS,
so that
C = Cd = ed(l;
cs =
cS(
I =
Is =
),
ld(C;
(IO)
is(.)
(sellers rationed in both markets)
(R) cd >
Cs, Id
> Is, so that
C = cs = es(l;
Cd
Cd (.
)
))
= Is = 1S(C;)
Id
(I)
Id()
(buyers rationed in both markets)

1 In this sense, neither pure fiscal nor pure monetary policy is really plausible in this model, if we
exclude a "helicopter drop" (or confiscation). Also, without taxation, a continuing positive level of
government expenditure would cause money balances to grow indefinitely. Putting taxation in the
model to correct this would burden the notation but would cause no essential difficulty.

I978]
(C)
MACROECONOMIC
cd > C8,
Id <
ls,
MODELS
so that
c = c
cd
= cs(.),
=
jd
Y;
795
RATIONING
QUANTITY
WITH
Id =
(I 2)
Id(.)
=
IS(C;*)
(buyers rationed in goods market, sellers rationed in labour market)
(U)
cd < cs,
Id
> Is, so that
I = Is = Is)
C = Cd = Cd(.),
cs
.)
j(l;
Id=
(I 3)
d(C; . )
(sellers rationed in goods market, buyers rationed in labour market).

Even our simple two-market model is evidently rather complex. An appropriate set of diagrams will help in understanding the interactions between
markets. Before we take them with full generality in Section 4, however, we
can introduce some basic notions here in the context of the simplest possible
example: the income-expenditure representation of the Keynesian model. The
standard income-expenditure diagram is given in Fig. I.
c+g
yC
Fig.
I.
The textbook income-expenditure

diagram.
~ ~
~ ~~~~~~~~YMl-g
C
F-g. 2. Fig. I in consumption-labour space.
The intersection of the 450 line and the total expenditure function determines
equilibrium output. Given the interaction between the goods and labour
maikets, there is a story about the labour market implicit in this diagram. The
first step in making the market interaction explicit is to translate the axes of
the diagram into consumption-labour space, as in Fig. 2. Now equilibrium is
determined by the intersection of the aggregate supply curve for consumption
goodls (the production function shifted downwards by the amount of
government demand - recall that the government is never rationed) and the
aggregate demand curve for consumption goods. This shows consumption
expenditure as a function of labour services sold. In Section 4 we elucidate the
using a
relations between goods and labour markets expressed by (IO)-(I3),
suitably extended and reinterpreted version of Fig. 2. First, however, we must
provide a microeconomic basis for the supply and demand functions of firms
and households in alternative constraint regimes.

796
3.
AN
JOURNAL
ECONOMIC
THE
VIEW
INTERTEMPORAL
OF
THE
HOUSEHOLD
[DECEMBER
AND
FIRM
For the household we introduce money balances, and for the firm, inventories
of finished goods; each has the function of a store of value. We shall make
explicit- more so than has been done by Barroand Grossman(I97I, I976),
Clower (I965), Malinvaud (I977) - that this role of a store of value is derived
from the future part of the objective functions of households and of firms.
Therefore the circumstancesexpected to prevail in the future can make this
role qualitatively as well as quantitatively different. For example, a household
which expects that it cannot sell labour next period clearly has a quite different
need for money balances than one which expects to be rationed in the goods
market. Analogously, a firm that expects not to be able to obtain all the labour
it would like next period has a quite different need for inventories of finished
goods than one that expects not to be able to sell all it would like next period.
Households have in reality a variety of stores of value by which to transfer
purchasing power from one period to the next. In wrapping them up in money
balances we are giving a stylised version of a more general theory of savings
behaviour. Similarly, firms can transfer purchasing or selling power through
time not only through inventories but money balances, other financial assets
and fixed capital. By considering only inventories we are nevertheless giving
the core element of a more general theory of the financial and investment
policy of firms.
For both households and firms we shall discuss a two-period model which,
given the recursive structure of intertemporal problems, extends to many
periods with no loss of generality.
(a) Households
We begin with a two-period model of a household which has expectations held
with confidence about the second period. Let us suppose that the utility
function is defined over consumption ct and leisure Tt-It, in the two periods
t =
I, 2:
UH =
U(C1, T,-
l,
C2, T2-12),
(I4)
U(.) is assumed to be increasingin all four argumentsand ct > , Tt > t -> o.

The second period budget constraint, given that it is intended to have zero
money balances at the end of period 2, is
ml+d2+w212 > P2C2)
(I5)
where w2 is the expected wage rate, p2 the expected price level and d4is exogenous non-labour income (either dividend payments or a government transfer
payment).
The household could in principle expect to be in any of four alternative
states in period 2: it might be unrationed, so that (I5) alone would be the
entire constraint; it might be rationed in the labour market only, so that (I5)
is supplemented by 124= ; it might be rationed in the goods market only, so
that (I5) is supplemented by c2 = c2; finally, it might be rationed in both.

I978]
MACROECONOMIC
MODELS
WITH
QUANTITY
RATIONING
797
However, if nothing beyond period 2 matters, and given that rationing must
always be an upper bound on consumption purchases c2 and labour sold 12,
constraints on both cannot be simultaneously binding. If a household were
rationed in the goods market, so that c2(.) > c-2, and had no use for endperiod money balances, it would not make sense to supply more labour than
12 =
(P2j2-
-Md2)
/w2. If the labour ration were below this level, then the
goods ration ?j would not be binding, since as much as C2could not be bought.
This allows us to neglect the possibility of simultaneous rationing in period 2
in both labour and goods markets. But notice that in a model with three or
more periods this possibility could re-emerge, and as we shall see, it could
certainly arise in the first period.
Let us solve the household's problem of maximising utility for period 2,
conditional upon cl and 1,. In the unrationed case the optimal levels of consumption c2 and labour supply 12will depend upon (ml+ d2)/p2, w2/p2and c,
and T, - 11.Substituting these levels gives the solved utility function:
UH
=-U{c,, T, -11, c2 [(ml + d2)/P2, w2/P2, C1DT1- l}l

T2-1[(m2 + d2)/P2, w2/p2, cl,T, -11] *
(i 6)
The fact that ml/p2 enters (i6) indirectlythrough the optimal levels of c2 and
'2makes explicit that the utility of money balances ml is derivedutility.
Analogously, when only labour is rationed by 12 < 12 and this constraint is
binding because 12 < 12(.), the budget constraint implies
C2= (ml+ d2+ W212)/P2,
so that
UH = U[CD,7T-lID (ml+d2+W212)/p2, 7 -12]
(I7)
When only goods are rationed by c2 < c2, and this constraintis binding because
-d2) Iw2, as long as
c2 < cll(.), the budget constraint implies m2= (P2c2>
o. Then
12
2 -ml d2)/wi2
(I8)
UH = U[Cl, TX-11 j2 T-(P2
The three functions (I6), (I7) and (I8) are sometimes called conditional or
mixed indirect utility functions' and make plain the different role played by
money balances, given the three alternative states of the world which can be
expected.
We are interested primarily in analysing decisions in the current period,
and to have to worry about three alternative utility functions with arguments
cl, 11and ml does not make for analytical simplicity: if there are four distinct
constraint regimes in period I, then there are I2 possible behaviour regimes
to consider for period I! This is probably why various authors have preferred
to write simply
UH = V(c,1 T,-1
('9)
Ml/P1)P
1 Such utility functions have been considered by Samuelson (1969), Fama (1970),
Epstein (1975),
Benassy (1975), and a number of other writers. Basically, they stem from the recursive solution structure
of dynamic programming problems -see Bellman (1953) and the discussion in Grandmont (1977a,
section2).

798
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However, this obscures the important role of expectations and assumes that
next period's price level is expected to be the same as this period's and that
the regime which actually prevails in period I does not affect expectations
about the regime in period 2.
The analytical simplicity of only one instead of three types of behaviour in
each of the four constraint regimes in period I can be obtained consistently in
two ways. In the first, one assumes that, for each regime in period I, there is
a unique expectation of which constraint regime will be operative in period 2.
Perhaps the most natural expectational assumption is that period 2 will have
the same constraint regime as period i. However, a second approach which
relies on an explicit, probabilistic Von Neumann-Morgenstern formulation is
rather more attractive. This involves the choice of a transformation of the
utility function whose expected value will be the new utility indicator to be
maximised. Because this will be an appropriately weighted average of (i6),
(I 7) and (i 8), the resulting utility function has as arguments cl, T1-11, mIn, T2
and the parameterswhich govern the (probabilistic) expectations of d2,P2, W2,
c2 and 12. If we absorb into the utility function the part of these parameters
which depends upon cl and 11,and let the rest of these parameters be represented by the vector 0, we can write
UH =
V(C1, T1-1l,
ml,
T2, 0),
(20)
where 6 depends at least on pl, w, and the level of dividend or transferpayments

in period i. Note that (20) is formally the same in an n-period model.
Now we can turn to the choices which have to be made in period i. The
budget constraint is
mO+?Wll
= plcl+ml,
(2I)
where exogenous dividends or transfer payments d1 have been absorbed in

initial money balances mo and where ml > o (no borrowing). There are four
constraint regimes: no rationing, rationing only in the labour market 11 = 11,
rationing only in the goods marketcl = jl, and rationing in both. The solutions
which arise in each of these four regimes are very simply illustrated in a diagram which has been used by Svensson (I977) and others. Substitute
ml =: MO+Wl1l -Pic]
from (2I)
into
(20),
to obtain
UH
= V(cl, T1-11, mo+wlll-plcl,
T2,
6).
(22)
Having thus absorbed the constraint, draw a constant utility contour map in
consumption-labourspace as in Fig. 3. The point H is the optimal point when
no rationing is imposed and represents the highest attainable utility. The coordinates of H are the unrationed goods demand and labour supply. These
must be functions of the vector of exogenous arguments of V(.) in (22):
(T1,MOn,w, PT2,
p1,
), which we denote by AH. So we can write
c
C-
11-
(AH) = C
I (AH)

23)
I978]
MACROECONOMIC
MODELS
WITH
QUANTITY
RATIONING
799
Suppose labour is rationed through 11 < 11 as illustrated in Fig. 3 by the

dotted line tangential to an indifference curve at A. The optimal consumption
level is given by AA'. Shifting the 11constraint rightwards to H traces out the
labour-rationed goods demand function (which could be kinked if the noborrowing constraint were binding). Now a further exogenous element 11 = 1
enters (22), so the demand for goods depends on 1, as well as AH 1
C1 = G (AH, 11)
where
GCD
(24)
11 = 11 < 1s(AH) = 11(

Cl
'
lS(c)X
/1 =Ti;
Fig. 3. The household's labour-rationed consumption function
and goods-rationed labour supply function.
Similarly, by shifting the goods ration level cl <s cl, and tracing out points
of tangency with the indifference curves such as B, one obtains the goodsrationed labour supply function
where
11 = Is(AH, cO) = ls, d

cl=&c <cd(AH) = cdJ
(25)
Finally, if the goods ration is cl < cl and the labour ration is 11 < 11, the
household is at a point such as C., Such a point is quite feasible. If both constraints are binding the household is accumulating money balances in the
amount
(26)
ml - MO= W, 11-P1i C.
Given 11 and cl, the household accumulates money balances given by (26),
apparently as a residual. But note that these are certainly not without utility:
1 Note that the ration 1, enters d(. ) not only as part of the budget (mo+ w, 11) but also by influencing
expectations and (unless the utility function is separable in 1) by affecting the rate of substitution between other arguments of the utility function.

800
THE
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ECONOMIC
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if they were, labour supply would be cut so that the labour ration would no
longer be effective. Formally,
11 <
11
C=
NA(H)
el)
lsb
A27
& < Cd(AH, 11) = C1.
The functions (23), (24), (25) and (27) express the effectivedemands and
supplies in each of the four constraint regimes respectively. When rationing
constraints are binding in one market, the effective demand or supply expressed on the other market, instead of being the notionaldemand and supply
(23), becomes the rationed demand (24) or rationed supply (25). The labourrationed consumption function and the goods-rationed labour supply function
meet at H in Fig. 3. Thus, the value of the labour-rationed consumption function (24) coincides with that of the unrationed function from (23) when the
labour ration in it, 11,is replaced by the unrationed labour supply from (23).
Similarly, the value of the goods-rationedlabour supply function (25) coincides
with that of the unrationed function from (23) when the goods ration in it, cl,
is replaced by the unrationed goods demand from (23). This is a fundamental
property of conditional demand functions (see Pollak, I969).
This consistency condition and indeed the simple form in which the effects
of rationing are representedin Fig. 3 rest on a continuity assumptionconcerning
expectations. This is best explained by an example in which the consistency
condition is violated. Suppose that the same rationing regime is always expected in period 2 as in period I. With labour rationing in period I, the relevant
utility function is (I 7), where 1 may depend upon 11. Replacing 11 by the
level of unrationed supply 1' does not result in the unrationed function (I6),
as is easily illustrated with a Cobb-Douglas utility function. The reason is
that the way 12 enters is conditioned not by the level of 11 as such but by the
regime in period I, which determines that of period 2. Thus there is a discontinuity: a small change in 11 can lead to a switch in regime and hence a
complete switch in the functional form of the relevant utility function.' To
avoid it we need to assume that expectations of period 2's regime are determined
as continuous functions of cl, 11 and prices, etc., but not of period I's regime.
This is quite a special assumption, which we shall make throughout.
The distinction between the form of the consumption function in (23) and
(24) is what Clower (I965) calls the "dual decision hypothesis". If the labour
market clears, consumption does not depend upon current income from the
sale of labour services - this is "solved out" in the household utility maximisation. The Keynesian consumption function (24) operates when households
encounter a quantity constraint in the labour market.
As discussed in Section 5, existence, uniqueness and stability of the quantityconstrained equilibrium require (among other conditions) that the consumption function C-d(l) and the labour supply function ls(c) have positive and finite
1 This is analogous to a discontinuity as the regime changes which can arise in the effective demands.
These also are conditional not merely on the ration level in the other market but on the regime as well.

I978]
MACROECONOMIC
MODELS
WITH
QUANTITY
RATIONING
801
slopes, with the latter steeper than the former.1 Given goods rationing to
cl = cl, one would expect labour supply to be less than that amount of rationed labour sales which would give rise to the same amount of consumption
demand. With labour rationing, one would expect the household to be running down its money balances unless it anticipated even more severe unemployment next period. With goods rationing, one would expect it to be accumulating
money balances unless it anticipated even more severe goods rationing next
period.
Leland (i 968) and Levhari and Srinivasan (i 969) replace the TobinMarkowitz theory of the precautionary demand for money, based on interest
rate uncertainty, by the precautionary demand for saving based on income
uncertainty. We have sketched a further generalisation suggested by Benassy
(I975) and Grandmont and Laroque (I976), introducing uncertainty about
rationing levels explicitly in both labour and goods markets. This is one reason
why we do not write "demand for money" functions. If we did, then as suggested above, under goods rationing we might expect 9md/Ic < o, which
makes sense when thinking of money as an asset but not in its pure transactions
role.
(b) Firms
In many ways, our theory of the firm parallels that of the household, with the
demand for inventory holding analogous to the demand for money balances or
financial assets more generally. One way of representing inventory deterioration or holding costs is
it - ht(it1) +Yt -xt,
Profit in period
where
ht(it-l)
< it-l
(28)
is given by
7Tt=txt-Wtl(Yt)3
where l(yt) is the inverse of the production function, the labour requirements
function.
As with the household, two approaches are possible. In the first, expectations
of next period's circumstances are held with complete confidence. The firm
is assumed to maximise the sum of the two periods' profits 7rT+7T2. Assuming
that inventory holdings at the end of period 2 have no role in the firm's objectives, (29) gives the analogue of the household's period 2 budget constraint:
0 < h2(i1) +Y2 - x2.
(29)
Again, three regimes can arise in period 2: no rationing either of sales or of

labour, sales rationing only and labour rationing only. Thus there are three
1 This in turn means that the major axis of the ellipsoidal iso-uHcontours must be positively sloped,
as drawn in Fig. 3. One can suggest examples in which it is flat or slopes downwards: households with
large asset holdings and strong complementary between current leisure and current consumption;
or households obeying an extreme version of the permanent income hypothesis; or households whose
expectations about labour rationing are negatively autocorrelated. In the aggregate, at least in regard
to the consumption function, the dispersion of asset constraints among the population is unlikely to
allow a perversely sloped consumption function.

THE
802
ECONOMIC
[DECEMBER
JOURNAL
conditional profit functions for period 2, each a function of the level of inventory holding il. For analytical simplicity one could assume that given the
constraint regime of period I, there is a unique expectation of the period 2
constraint regime. For example, one could assume that the firm never expects
to be rationed in period 2. In a brief appendix, the period I behaviour which
results on this assumption, making specific assumptions about the form of
h(it) and l(yt), is worked out for illustrative purposes. But as for households,
the explicitly probabilistic approach is perhaps more attractive. Letf2(&T2) be
a concave function, so that the firm is risk averse, and make the objective
function the expectation of an additive function of iT and T2:
max
(fl(7TO) +E{ff2 [1T2(i1,
conditioning variables)]}).
(30)
The expected value of transformed profits in period 2 will be a weighted

average of the three conditional profit functions, and this collapses into one of
the three regimes which could occur in period 2. Another analytical advantage
of this approach is that under the non-probabilistic approach, one needs a
convexity assumption on the inventory survival function ht(it-1), as well as
on the labour requirements function l(yt), in order to avoid "bang-bang" solutions (in which desired inventories switch from zero to some positive value
under a marginal change in one of the constraints). With the probabilistic
approach, the concavity of the objective function makes this unnecessary.
Whichever approach is taken, we can now derive the various types of behaviour in period I under the four constraint regimes which can arise. Let
E{f2[7T2(i1,
conditioning variables)]} - f * (il, 11,xl, 3f),
where 34 is a parameter vector which reflects those parts of the probabilistic

expectations about 12, x-2,P2 and w2which do not depend upon il, 11 and xl.
Thus the objective is
max UF
subject to
= f1[pixi
il = hk(io) +y1-xx
+f2
WI I(yi)]
[ii, I(yi),
X1, 4]
(3I)
(il _ o, y1 > o, xi > o).
Substituting the constraint into the objective function allows UF to be expressed

as a function of sales xl and either output Yi or employment 11. In the latter
case,
Up =f1(plxl-wlll)
(32)
+f*[hl(io) +y(ll)-xl, 1i, xl, "]
In Fig. 4 the point F is the optimal point when there is no rationing. The coordinates of F are the unrationed goods supply and labour demand. These
must be functions of the vector of exogenous arguments in (32): (io, P1, wl, 0f),
which we denote by AF. Then the unrationed supply function of goods and
demand function for labour may be written
X1
l1
xs(AF)
xl,]
i1.J
(AF) =

()
I978]
MACROECONOMIC
MODELS
WITH
QUADNTITY
RATIONING
803
If the amount of labour the firm can obtain is rationed but sales are not, the
labour-rationed supply function of the firm is
xi =
where
s(AF, 11) = xlD
11 = 11 <
(34)
Id.J
Id (AF)
x1
OX,
/ (Xl)
/l
Fig. 4. The firm's labour-rationed supply function

and sales-rationed labour demand function.
If the amount of sales the firm can make is rationed but labour is not, the sales
rationed labour demand function of the firm is
11 = I X(A, x =)
where
xi
x-
<
ld
xS(AF) = xl.J
Finally, the last possible constraint regime arises when the firm is rationed in
both markets. Then
1| = 1 < Id(A?, X1) = d1,l
(36)
and
x=
< xS(AF, 11) = xl.J
As indicated, the respective functions (33)-(36) represent the effective supply

and demand functions of the firm under the four possible constraint regimes.
Given the continuity of expectations discussed above, the rationed functions,
(34)-(36), must give the unrationed functions when the ration levels are
replaced by the appropriate values from (32) and (33).
The respective functions determine the demand for inventories through equation (28). As the simple illustrative model examined in the Appendix shows,
the demand for inventories will be particularly high if it is more profitable to
sell next period and more difficult to sell this period. It is worth pointing out
that in the fourth constraint regime where the firm is rationed in both markets,
both Yi and xl are fixed and
il-h1(io)
= Yi(ti)
-xi

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THE
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[DECEMBER
represents the inventory accumulation of the firm. Although this looks like a
residual, the firm could in fact choose to produce less and accumulate fewer
inventories. If the firm did not believe that they could be sold profitably next
period, it would cut production and no longer find itself rationed in
labour.
We have not analysed the shut-down decision of the firm explicitly or the
possibility of corner solutions which can arise if one of the restrictionsil > o,
y, > ?, xl > o is binding. These can be understood to be included in the
definition of the various demand or supply functions above, which may therefore have kinks.
We have treated money balances and dividend payments as exogenous:
although they enter the accounts of the firm they do not enter into the decisions
of the firm which we have analysed. Implicitly, we have assumed that firms
always have sufficientretained or current profitsto be able to finance inventory
accumulation. While in principle one could write down an indirect utility
function for the firm which would include money balances and dividends, this
derived utility stems from transactions in financial markets and markets for
fixed investment which are outside the scope of our simple model.
Finally, it must be pointed out that saving (and particularly the money
component in saving) acts as a buffer stock, absorbing unanticipated shocks.
This role is in part already implicit in the theory: each period the household
replans in the light of new information and consequently takes correcting
action for past mistakes. The concept of equilibrium here can accommodate
such bufferstock behaviourwithin the period, as long as we take the equilibrium
to be reached at the end of the period, after a process of adjustment. Our
concept of equilibrium requires that the perceived ration coincides with the
actual ration so that neither buyers nor sellers have any incentive to change.
However, we can think of a sequence of very short periods in which the current
ration levels are interpreted as perceived levels which may start different
from the actual ration levels but converge to them by the end of the sequence.
This tdtonnement
on quantities is part of the familiar multiplier process.
Inventories play a similar buffer stock role in this process. If households
suddenly decide to increase their expenditure, the increase causes an unexpected drop in inventories as sellers meet the unexpected demand increase by
selling from inventories. If we interpret xl, for example, as the perceived sales
ration in the current period, the theory of the firm as formulated can accommodate an error in this perception: the firm will then have made an error in
its employment and inventory plans. Information on this error materialises
from the inventory levels which, if xl underestimated demand, will be unexpectedly low. In the next short period, plans will be made in the light of
actual inventory holdings and of revised views on the sales ration. Such a
process is likely to converge quickly to an equilibrium in which the perceived
sales ration is the true one. While such a process is working itself out in the
very short run, we can say that the economy is "in disequilibrium", and this
is really the only sense in which this class of models can be said to be about
disequilibrium. The information generating role of buffer stocks suggests that

I978]
MODELS
MACROECONOMIC
WITH
QUANTITY
RATIONING
805
models with quantity rationing do not, after all, require as much centralised
co-ordination as Grandmont (I977b), for example, argues.
4.
THE
COMPLETE
MODEL
We must now aggregate the behavioural functions of individual households

and of individual firms which we have derived in the previous section. The
simplest way of doing so is to assume that all households are identical and when
rationed are rationed identically and analogously for firms. However, the same
basic diagrams hold if these assumptions are substantially relaxed, though the
slopes of the functions may be somewhat different and the microeconomic
story will differ for different households or firms. For example, if initial money
balances mo (including exogenous income) differ across households, and labour
supply diminishes with mo, then under the equal labour ration 1, some affluent
households would offer less than I and hence not be rationed. Then the aggregate labour-rationed consumption function will be a weighted average of the
rationed micro-functions of the less affluent and the unrationed micro-functions
of the more affluent. Also, 1 then exceeds the aggregate labour demand of firms
divided by the number of potential workers, but is a monotonic increasing
function of this level. Even with the simplest linear functions and all households having the same tastes, different distributions of mo result in different
aggregate behaviour.
A similar result would follow if unemployment always took an all-ornothing form, i.e. zero hours or no constraint on hours at all. This might occur
each
under "efficient" rationing of labour as assumed by Malinvaud (I977):
firm has a fixed coefficient technology, and less efficient plants are the first to
be closed as effective demand drops and production and employment are
curtailed.
In practice, if firms follow rules such as "last hired, first fired", for which
there is empirical support and some theoretical explanation - see Hall (I97I)
and Oi (i962) -it seems likely that the less well paid will bear the brunt
of increased unemployment. The consumption reduction per worker will
therefore be smaller than if the incidence of unemployment were random.
"Efficient" rationing has a useful analytical advantage in aggregating over
firms: it implies a unique association between the aggregate level of sales, the
aggregate level of labour demand and the aggregate level of implied inventory
demand. However, while efficient rationing in this sense is plausible within a
multi-plant firm, it assumes a level of economy-wide co-ordination between
firms which does not, strictly speaking, make sense in the context of the informational failures implicit in the whole notion of non-clearing markets.
Random rationing, with independence between the distribution of sales rations
across firms and the various characteristics in which firms might differ, would
be an alternative motivation for our assumption that there is a unique association between the aggregate level of sales and the aggregate level of labour
demand.
Finally, a brief remark on the non-manipulability of rationing schemes,

8o6
THE
ECONOMIC
JOURNAL
[DECEMBER
which we assume throughout. One example where this would be violated

occurs if households take time to visit shops of which a percentage are out of
the goods they wish to buy when goods are rationed. Search behaviour then
becomes endogenous and may influence labour supply. We wish to avoid the
complication of an extra endogenous variable.
We can now set out the complete two-market model, algebraically and diagrammatically. Dropping subscriptswhere the meaning is clear from the context we have
{d(AH)
ed(AH,'
if
1) if
xs(AF) -g
Xs(AF l)g
c
= min (Cd,
Is > ld
if
if
Is
1=
Id = I}
|s
(38)
<ld
(39)
Cs);
ltd(AF)
if
C =
cs <
Id (AF, C+g)
if
Cs >
Cd =
l=S(AH)
{S(AH,c)
1=
(37)
(37
1 = Is
if cs
if
Cd
C(
cd =c,
(4)
C = Cs < Cd,
min (id, is).
(42)
Quantity rationing itself is only part of the complexity of the model. It is

the combination of minimum conditions and switching conditions in interacting markets which may make it difficult to follow what is going on, as well
as to estimate such models.'
We now consider alternative constraint regimes. If both markets clear, we
are of course in Walrasian equilibrium. Translating Fig. 4 into (C,1) space and
juxtaposing it with Fig. 3, we may represent Walrasian equilibrium in Fig. 5,
where W is a point at which F and H coincide. Fig. 5 is the first of the " double
wedge" diagrams with which we shall portray the various regimes.
The relative slopes assumed for the households' and firms' functions in Fig. 5
and the other diagrams in this section will be discussed in Section 5. They
reflect assumptions required to get existence, uniqueness, and stability of the
various quantity-constrainedequilibria.
Disregardingother borderlinecases,2we have four possibleconstraintregimes,
as specified in (IO)-(I3) and diagrammed in Figs. 6-9.
Keynesian unemployment equilibrium (K), with excess effective supply in
1 It should be noted that empirically, the fact that any rationed function will coincide with the
corresponding unrationed function when the ration level equals that which would have been chosen
freely - e.g. Cd[ls(.)] = cd(.) - does not justify simply estimating the former if the period of observation includes both rationed and unrationed points. For the latter points, the quantity "ration" is
in fact endogenous, and this will bias the estimated coefficients.
2 If one wishes to assume that price or wage adjustment clears one of the two markets, then the
cases along the boundaries of regions (see below) become important, but they raise no new issues.

1978]
MACROECONOMIC
MODELS
WITH
QUANTITY
RATIONING
w
-d
C
-d
la
Fig. 5. Walrasian equilibrium in quantity space.
cs
-----
xd
H
ed
/s
d~~~~~I-
C
_
__ C 6. Keynesian
unemployment.
Fig.
xd
Fig. 7. Repressed inflation.
cc
-d
I_Ce
S
Fig.6. Keynesicanxdunemployment.
unemployment.
Fig. 8./Classical
S
xd
d
Fig. 7. Rnepreossemifltion.
Fig. 9.

807
8o8
THE
ECONOMIC
JOURNAL
[DECEMBER
both markets, is realised as an intersection of the labour-constrained demand

function for consumption goods and the sales-constrained demand function for
labour. Repressed inflation (R), with excess effective demand in both markets,
is realised as an intersection of the consumption goods-constrained supply
function for labour and the labour-constrained supply function for consumption
goods. In classical unemployment (C), households are on the long side in both
markets, and the firms' notional demands are realised. Firms will not hire
more labour to satisfy the excess demand for goods because it would be unprofitable to do so - the real wage is too high. In the fourth case, which we
call underconsumption (U), firms are on the long side in both markets, and
households' notional demands are realised. Note that intersections of ld(c) and
Is(c), or of Cd(l) and Ps(l), with both sides rationed on the same market, can
never be observed.'
Voluntary exchange requires that households be on or within the "wedge"
formed by
&d( .)
and is(.) and that firms be on or within that formed by
es(.)
and Id(.). As noted in Section 3, to be within the wedge means a double constraint on the relevant set of agents, and this occurs in C and U. This is an
important difference between R and C for households, and between K and U
for firms.
In R, households facing goods rationing adjust their labour supply and saving
behaviour. They move along 15(.), substituting leisure and future consumption
for the unobtainable present consumption. The "supply multiplier" process
(involving a fall in output as labour supply falls, and further adjustment by
households) is assumed to work itself out in the unit period, and in equilibrium
they are supplying the amount of labour and accumulating the amount of
assets which they desire, given the constraint facing them. Although there may
be "forced saving" in the sense that they are saving more than they would in
the absence of the constraint, this saving is desired to finance future consumption, given their expectations about future constraints in the goods market; if
it were not, they would reduce labour supply still furtber. In C, however, this
option is not open: they are already constrained to sell less labour services than
they would like, even taking into account the rationing in the goods market.
Given the level of employment, they cannot consume as much as they would
like and are accumulating some money balances which they would rather
spend this period than next but cannot. Note, however, that they would rather
have them for next period than work even less.
For firms, the contrast between K and U is analogous. In the former, they
can adjust employment downwards to reach their desired level of inventory
accumulation, given the sales constraint facing them (the "demand multiplier"
process is assumed to work itself out). In the latter, they cannot, but given the
labour supply available, they are selling less this period than they would like
(though it is nevertheless profitable to produce for sale next period).
1 Note also that in Fig. 6, there is no need for F to lie northwest of H; there could also be a Keynesian
equilibrium with F southwest or northeast of H (but not southeast - there cannot be excess effective
supply in both markets with excess notional demand in both markets). Similarly, we could have a
repressed inflation equilibrium with F southwest or northeast of H.

I978]
MACROECONOMIC
MODELS
WITH
QUANTITY
RATIONING
809
It is debatable whether the excess effective demands shown on the diagrams

and interpreted above are appropriate measures of the "pressure" on prices
in non-clearing markets (see Kornai,
I97I;
Portes,
I976,
I977).
In so far as
they are, the endogenous forces for relative price adjustment to clear markets
may be very weak. Walras's Law applies for the notional demands, but it
need not hold for the effective demands in a quantity-constrained equilibrium.
In the simplest case, with g = Am = o and no inventory accumulation, the
sum of the excess effective demands is just W(ld -Is) +p(cd -Cs), since
Amh + Amf = Am = 0.
In K, both terms are negative, and we have "generalised excess supply"; in

R, both terms are positive, and we have "generalised excess demand".' In
neither case do we find the self-correcting tendencies invoked by Walras's Law,
so price flexibility may be of little help in moving the system towards a Walrasian equilibrium.
The double wedge diagrams in (c, 1) space represent the various configurations of the two-market system neatly, and we will manipulate the same apparatus for comparative statics in Section 5. Other authors work primarily with
diagrams in (w, p) or (w/p, m/p) space, however, and it may be helpful to
set out the former as an example and indicate the advantages and disadvantages of the alternative approaches.
w
(.)=Is
I
( .)
I+
11/
IV
p
Fig. Io. Loci of notional equilibria in wage-price space.
Fig. IO shows loci of notional equilibria. Assuming the normal signs for the
relevant partial derivatives given in Section 5, it is straightforward to show
that dw/dp > o along each locus. The signs on either side of each locus indicate
regions of excess demand (+ ) and supply (-). To see why the curve Cd(.) =Cs
is steeper, note that this configuration makes region I have general excess
1 In the general case with g = Am > o, we reach the same conclusions from the version of Walras's
Law which does hold in quantity-constrained equilibrium: the sum of excess effective demand for
unrationed goods is zero (the only unrationed good here being money).

8io
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[DECEMBER
supply and region II general excess demand, so that low w and p have a positive
real balance effect on demand.' Now consider the efective demands and supplies. When there is excess supply in one market, that lowers the effective
demand in the other relative to the notional demand there; thus the region of
general excess effective supply (which we denote by K) must contain that of
general excess notional supply. An analogous argument applies for general
excess demand. Hence when we go from notional to effective demands, regions
I and II expand, so regions III and IV must contract, and we obtain Fig. II.2
The curves are now those on which effective demand equals effective supply,
and therefore they divide wage-price space into regions corresponding to those
defined by (i o) to (I 3).
w
d s
C =C
~ ~~~~~~~~~
/=1
d s
Fig.
i I.
Loci of effective equilibria in wage-price space.
This type of diagram subsumes the attainment of a given quantity-constrained

equilibrium in the background, parameterising it with the exogenous variables
and working directly with these. This has some advantages in comparative
statics, since one can see immediately towards which regime a given change in
w and/or p will shift the system. It also facilitates using phase diagrams in
dynamics, but it ignores both the process by which a quantity-constrained
equilibrium is attained and the interaction of markets through quantity signals,
which is the central feature of this class of models. Thus it is the representation
in quantity space which is most useful in econometric applications (for example,
see Portes, 1977, and references cited there).
These models are intended to be for short-run fix-price quantity adjustment;
which wage-price vector would get us to W is unimportant, and the direction
1 Alternatively, draw a phase diagram for tdtonnementand observe that the intersection is stable,
whereas with the opposite slopes it would be a saddle point.
2 We owe this argument to Avinash Dixit.
3 It can be maintained that Keynes himself assumed that the goods market clears, so that the
" proper" Keynesian case would be on the border between C and K in Fig. I 1, or with F lying on C(.
to the left of H in our diagram.

1978]
MACROECONOMIC
MODELS
WITH
8I I
RATIONING
QUANTITY
in which the existing (w, p) deviates from that at W is only slightly less so.
Even in dynamics, to focus on wage-price adjustment instead of quantity
changes in this context seems misplaced. We therefore prefer for most purposes
to work directly with the endogenous variables.
Time plays an essential role in the macro model we have set out in this
section. We could have proceeded with an atemporal model of the firm, the
only asset then being household money balances. In this case, there can be no
equilibrium of type U. For if firms cannot carry inventories forward for sale
in the future, and they face excess supply of goods, they will not seek to hire
more labour than they already employ, merely to accumulate more stocks of
unsaleable goods. Rather, they will cut back on labour use until production
is no greater than what they can sell in the current (the only) period. Consequently, the goods-constrained demand for labour function becomes the inverse
of the labour-constrained supply of goods function, which makes the distinction
between them less obvious. The F-wedge collapses to a single curve representing
both &s(l) and ld(c), the production function shifted downwards by g. Disregarding borderline cases, we have three possible equilibria, seen in Figs. I2I4. These cases are analysed in detail by Malinvaud (I977).' Note that Fig. I2
H
K
Fig.
I12.
Keynesian unemployment.
Fig.
I 3.
H
F
Repressedtinflation.
Fig.
I 4.
Classical unemployment.
is effectively Fig. 2 above with the addition of ls(C), which is nlot relevant in
the Keynesian regime. This means that the production function in Fig. 2
which is the translation of the 450 line in Fig. I iS the goods-constrained labour
demand function.
If we now consider a fully atemporal model, we find that the interaction of
markets through quantity constraints generates inconsistencies. Analogously to
the argument above, we can rule out the possibility of regime C. Suppose
households hold no money balances at the end of the period, because there is
no future in which they could be used. If they face excess demand for goods,
they will not seek to sell more labour merely to accumulate unusable money
balances; they will instead withdraw labour until they are earning no more
than they can spend. Their goods-constrained labour supply function is now
u s(C) cothe inverse of their employment-constrained goods demand function;
The intersection of this single H curve with the F curve of
incides withed(l).
1 Malinvaud (1977, pp. 123-5)
also considers an ad hoc objective function for firms incorporating
inventories, but it is not based on any intertemporal model of the firm.

8I2
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ECONOMIC
[DECEMBER
JOURNAL
Figs. I2-I4 would give a picture identical to Fig. 2, which would now appear
to represent simultaneous determination of interacting quantity-constrained
equilibria in both the goods and labour markets.
On this interpretation, however, the intersection of Cd(l) and ld(c) would
coincide with that of es(l) and is(c), and we would have equilibria of both
type K and type R with the same data at the same (c, 1). This is the paradox
mentioned earlier. If the labour supply function is the inverse of the demand
function for goods, and the labour demand function is the inverse of the supply
function for goods, the system is underdetermined. We have two markets and
only one independent equilibrium condition. The static system is underdetermined because behaviour is overdetermined: neither households nor firms
have the extra degree of freedom offered by the opportunity to hold an asset
for future use. This is not to say that static models are necessarily inconsistent
when wages and prices are flexible, but under sluggish wage and price adjustment, they cannot generate Keynesian effects.
5. COMPARATIVE
STATICS
DYNAMICS
AND
It is straightforward to do standard comparative statics exercises with the

apparatus of Section 4. For example, starting in regime K, an increase in
government expenditure shifts the F-system down, and the intersection of Id(.)
with Cd(.) moves up and to the right along cd(.). In fact, we have the usual
demand multiplier, translated into (c, 1) space:'
dc =
(adl|)
(aldOaC)] dg
Qjl]
dg,
(43)
dl
[I - (@cd/9l)
(cd/@9c)j
dg
&ld/&]dgc
Notice that the marginal propensity to consume, aCd/lc, consists of the consumption demand response to sales of labour and the labour demand response
to sales of goods. The reader can easily verify that excess effective supply falls
in both the goods and labour markets. One can similarly investigate the effects
of a wide variety of such parameter changes, starting in each of the different
regimes, in the manner of Barro and Grossman (1976) and Malinvaud (1977).
The analysis of Section 3, with its explicit treatment of intertemporal and
expectational effects, should however suggest considerable reservations about
the value of such exercises. Here we have expectations not only on prices but
also on quantities, and they may often dominate the simple contemporaneous
effects. Thus in the example above, falling excess supply of labour may make
households revise their expectations about future unemployment optimistically,
and therefore feel less need for real balances to carry forward, and hence
increase current demand for goods. Meanwhile producers are also revising
1 Note that with inventories the multiplier is smaller than it would be without them. The expressions
in (43) are increasing in a4/lac, which is for any c normally less than its analogue in the case without
inventories, i.e. the slope of the labour requirements function (inverse of the production function).

I978]
MACROECONOMIC
MODELS
WITH
QUANTITY
RATIONING
8I3
their expectations about future demand for goods optimistically, so they increase
their demand for labour. If expectations are fairly sensitive to observed rationing, this may generate a good deal of instability. Indeed, the power of quantity
expectations and their interactions with each other and with current variables
tends to give the analysis much more of a "bootstraps" character than in
models with only price expectations.'
The "bootstraps" element becomes even clearer when we realise that although each of the constrained and unconstrained demand functions derived
in Section 3 does incorporate expectations, these are defined with respect to
the agent's initial position. There is no ahistorical, abstract consumption function. Each function must be referenced by the starting point. Thus in Fig. 15,
Cd(l) is the labour-constrained consumption demand function when the goodsconstrained demand for labour function is tj(c) and the equilibrium is K,.
c
F2
K,
C'E
Fig.
I5.
Comparative statics wheh household expectations

depend on initial conditions.
When the demand for labour function shifts to t2(c), the system moves along
cld(l) to K2. But having arrived there (accepting this arbitrary periodisation),
expectations are affected by being in K2, and the new consumption demand
function is (say) Cd(l) . The same point of course applies to the F-system.
In principle, therefore - and certainly in practice - we ought to specify the
expectations side of the model much more closely before trying to make any
statements in comparative statics. Nevertheless, we might take results derived
by assuming inelastic expectations as some indication of directional effects, and
also as giving us some insight into the different conditions generating different
types of equilibrium.
Thus if we start from Walrasian equilibrium and increase mo (a helicopter
drop) or g, we move into R in two different ways: if mo is higher than that
I This is apparent in the model of
Varian (1977), which includes an explicit quantity expectations
mechanism. The author remarks, "In the effective demand model, this type of inefficient, 'selffulfilling expectations' is the rule" (p. 579).

814
THE
ECONOMIC
JOURNAL
[DECEMBER
consistent with W at given wages, prices and other data, then the H-system
will be to the northwest of W (both consumption demand and labour supply
effects); whereas if g is higher, the F-system is shifted downward (see Figs. I 6I7). In either case, we have an intersection of ls(c) and es(l), and in the latter
we could represent the "process" of contraction as the intersection moves
along the curves by the "supply multiplier" (see Barro and Grossman, I974):
dc
s/ l) ( )i
Cs/
s/(a
- I[-
] dg
aisl ac
I (a-s/ac) dg.
_islac
dl = - [I-(ae&/al)
dg (ais/@c)1
dg,
(&s/Cl/)]
(44)
H'(mn'0)
-d
RI
(inces
T~
Wn
/F(gi)ras n)
T
~~
Ac
/8
whichrequinretatste ingood-ontaie
/s
@)
demad
nfrelaseu
g curv
nerec
the labour-constraineddemand for goods curve from below, and that the goodsconstrained supply of labour curve intersect the labour-constrainedsupply of
goods curve from below. To these we add the assumptions we made in constructing each "wedge":
O <
5sd/@l <
I /(01
/@C),)
(46)
O < aC/l<
Il(alcllaC).
It will be apparent that if we impose these conditions on the slopes over the
whole of the relevant range of variation of and c andTadd some global boundary conditions, we can get an existence-uniqueness result. Bfhm (I976) does
this for the case with no inventories. Given that Cd(.) has a positive intercept
and os(.) a non-positive intercept on the c-axis (the latter is not trivial when

I978]
MACROECONOMIC
MODELS
WITH
QUANTITY
RATIONING
8I5
there are inventories), the most important additional requirement is that is(.)
intersect the i-axis to the left of &s(.). This means that government cannot take
an excessive share of output, and household real balances cannot be so high
as to cut back labour supply substantially.
Given the signs of the partial derivatives of the various functions, one may
explore the comparative statics properties of the model by shifting the H- and
F-systems appropriately. We make the following not implausible assumptions:
aCdlaMo
>
o,
aCd/lw
acdlaMo
>
o,
ajdl
aW
ais/
ais amo < 0,
>
o,
aCd/lp
< o,
>
o)
ajdlap
<
0o,
aisl/p
0,
4ac-s/ap>0
ald/ aW < o,
adl ap>
ais
,a6l
,
> 0o
= 0)
< o, bIs/@9= 0, a9is/p > 0,

ais/@mo
acs/9w < o, acs/9p > o,
acs/@w= o,
acd/@l
ais/
> 0,
> O,
>
aldl aW< 0) aldl ap = on aldlaC > O.

The unconstrained labour supply response to an increase in the money wage
is assumed non-negative but small, and since a change in the price level has a
real balance effect of opposite direction to the real wage effect, we assume
als/lp = o. Since the income effect on labour supply of a money wage increase
is likely to be relatively greater when households are rationed in the goods
market, we assume ails/w = o. If firms are constrained in the labour market,
a change in the current money wage will not affect their current period consumption goods supply, so 9&S/lw = o; similarly ald/lp = o. Fig. I8 summarises some results:' The arrows show how increases in g, m0, p and w would
affect excess effective demand in each market in a given regime.2 Some of the
effects of price and wage changes shown are in fact ambiguous, depending in
particular on assumptions about the relative strength of labour supply effects.
The ambiguities are stronger when we look at the effects of parameter changes
on employment and output, which are summarised in Table I.
Two important points may be noted. First, starting in a given regime, the
regime towards which a given parameter change moves the system may differ,
depending on precisely where the system is at the outset. For example, starting
in K, an increase in g may go in the direction of C or of U. Secondly, it is
evident that a single policy instrument cannot in general bring both markets
to Walrasian equilibrium simultaneously. A single instrument might reduce
the size of excess effective demand in each market, but there is always the
danger of overshooting, and some policies reduce excess demand in one market
at the cost of aggravating it in the other.3
1 This was suggested by John Black.
An upward shift in the production function or an improvement in the terms of trade would have
the same effects as a fall in g.
3 This is essentially the point made by Ehemann (I974).
2

8i6
THE
[DECEMBER
JOURNAL
ECONOMIC
s)
(Cd-C
dw
dg, dm0
dw
dg, dn0
dp
dp
dw>O,dp<O
dg>O,dm0>O
dg<O,dmo<O
dp>O,dw<O
dw
dg, dno
dw
dg, dm0
U
dp
dp
Fig. i8. A schematic outline of various comparative statics results.
Table i
and Output
StaticEffectson Employment
Comparative
K
dw
dp
+?
+
o
o
dm
dg
+
+
U
?
o?
-
In going fromone periodto the next, the governmentmay have new productiveassetsand new liabilities(Am),while firms'inventorylevelsand households' money balances will in general have changed (Ai, Amh), and this
period's dividend payments may differ from those of last period. These are
endogenously generated changes in quantities; to them, one might wish to add
price and wage adjustment, if we believe that this will follow upon quantity
rationing. Again, we may represent these dynamic phenomena in (c, 1) space
by shifting the H and F systems, or moving in (w, m) or (w,p) space when
appropriate. Barro and Grossman (I976), Bohm (I976) and Varian (I977)
work out some dynamic paths, and less formally, Malinvaud (I977) puts some
arguments about long-run behaviour of the system. Any such analysis, however, should take account of the full range of intertemporal changes in asset

I978]
MACROECONOMIC
MODELS
WITH
QUANTITY
RATIONING
8I7
holdings outlined above, as well as expectational effects. There is clearly a great

deal of work to be done before wvehave realistic dynamic representations of the
quantity-constrained macro models discussed in this paper.
6.
EXTENSIONS
Finally, we discuss briefly some important respects in which these models need
to be qualified or extended. First, markets for fixed investment and financial
assets should be added. Barro and Grossman (I976) take a significant step in
this direction. Assuming (as they do) that financial markets always clear and
that investment goods are perfect substitutes in supply for consumption goods,
there is only one significant extra dimension, the endogenous interest rate. A
more complicated alternative would be a two-sector model with the possibility
of rationing in both consumption and investment goods markets.
More fundamental in many ways, because it may change the very notion of
equilibrium with which one works, is the question: who sets prices and wages?
One possible answer is: unions, industry price leaders, government; and this
direction has been pursued by Benassy (I978). Giving these decisions to a
different set of agents leaves the microeconomics of our paper valid though incomplete. An alternative possibility is to pursue Arrow's (I959) recognition that
markets which do not clear are not perfectly competitive and attempt to model
the conjectural demand and supply schedules of households and firms explicitly.
Such an analysis suggests some insights into the prevalence of different regimes.
Under excess demand in the goods market, sellers' temporary monopoly power
is likely to be reflected in relatively price inelastic conjectured demand curves,
and the resulting tendency to raise prices suggests that excess demand episodes
(repressed inflation or classical unemployment regimes) are unlikely to endure.
Under excess supply in the goods market, sellers are weak, their competitors
being flush with inventories. Then the theory of kinked oligopoly demand will
apply as Negishi (I976) argues and downward price rigidities will be the rule,
at least in the early part of recessions. Together with similar asymmetries in
though the presence of unions is
the labour market (see Flemming, I975),
to excess demand for labour, this
sensitive
less
increases
wage
make
likely to
suggests that Keynesian unemployment will be the most commonly observed
regime, with underconsumption essentially incompatible with the existence
of powerful unions. A proper microeconomic analysis of conjectural equilibria
will need to combine the insights of the Negishi (I960) model of monopolistic
competition (see Hahn, I977 b) - with those of the recent literature on market
behaviour under imperfect information (see Rothschild, I 973; Stiglitz, I 975).

A third important question concerns international trade. Dixit (I978) applies
the quantity-constrained model to a small open economy with a fixed exchange
rate, in a world where all goods are traded and the goods market always clears.
Thus the economy's goods market also clears, but labour is immobile, so excess
supply or demand can arise in the labour market. In such a system the state
of the labour market is unaffected by variations in government expenditure,
which change only the balance of trade. This is an extreme case, however:

8I8
THE
ECONOMIC
[DECEMBER
JOURNAL
even a small open economy need not face perfectly elastic supply and demand
schedules for tradeables if the goods market does not clear at the level of the
world economy. Arrow's argument then suggests that a more general model is
needed to analyse open economies.
Even in the international economics literature, where the extreme small open
economy assumption has been so convenient, an asymmetry is increasingly recognised. Although a small country may well face a very elastic supply of goods
from abroad, it may be fairly specialised as an exporter and thereforeunable to
sell all it wishes. This may help to explain why we observe Keynesian unemployment more often than classical unemployment. Similarly, the possibility of meeting excess demand for goods through imports makes repressed
inflation fairly rare, except when imports are restricted (as in wartime or in
centrally planned economies). Clearly, introducing foreign trade in a more
realistic way would increase the applicability of the quantity-constrainedmacro
model considerably.
Finally, we come to questions of aggregation and spillovers. Taken literally,
the model we have presented can be thought of as a macroeconometricmodel
with discrete switching between distinct regimes, and hence as a rather complicated extension of the recent literature we have mentioned on the econometrics of non-clearing markets. One difficulty with this approach arises in
aggregating, as for example over labour markets,where it seems more plausible
that different submarkets may be in different regimes but that the relative
dominance of the different regimes can change. Another arises when there is
excess demand for "the" consumer good. In reality with a range of consumer
goods, there will be "forced substitution" (Kornai, I97I) from those in excess
demand to those in excess supply at the given non-market-clearingprice vector.
Thus there will be differentintensities of rationing, depending on the elasticities
of substitution and how far consurnersare forced to switch, and the very concept of aggregate excess demand becomes ill-defined (Portes, I976).
These phenomena of aggregation and spillovers, as suggested by Muellbauer
(1978), can have a fundamental impact on the empirical and statistical forms
taken by macroeconomic models constructed in the spirit of the theory we
have presented. Such models are likely to be rather different from the macroeconometric models which are currently popular, whether one represents the
theory in the form of discrete switching between regimes, as we have done here,
or attempts to aggregate explicitly over submarketsin different regimes.
BirkbeckCollege
BirkbeckCollege
HarvardUniversity
JOHN
MUELLBAUER
RICHARD
January1978
Date of receiptoffinal typescript:

PORTES
I978]
MODELS
MACROECONOMIC
APPENDIX:
Malinvaud
A SIMPLE
WITH
MODEL
INVENTORY
8I9
RATIONING
QUANTITY
OF
THE
FIRM
complemented by Hildenbrand and Hildenbrand
(I977),
(I976),
gives an explicit analysis with particular utility functions of a macro model

of the kind we discuss in this paper. However, they take a static model of the
firm. Readers may wish to juxtapose their representations of household behaviour with the following dynamic model of the firm, which is one version
of what underlies Fig. 4.
We shall assume that the inventory survival equation (28) can be represented
by
(A I)
+Yt-Xt
it = it-,12ait-1
and that labour requirements, the inverse of the production function, are given
by
where ac,f8and y are constant parameters. Appropriate choice of units allows
us to take y = I.
Let us assume that the firm is unrationed in period 2, where its maximisation
problem is therefore
max 72=
+ 21Y22)
P2X2-W2(,2
subject to
(Y2 > o,X2
o?=il1-jcxi1+y2-X2
" o).
It is easily shown that the optimal level of production is
Y2= P2/W2-ft.
The unrationed period
profit level is therefore
1cil+p2/w2-ft) - w2Efjp2/w2-ft2 + i(p2/W2 _t)2]
2-
(A 2)
= 7r2(i1,P2, w2).
Given these expectations, the period I maximisation problem - see

max up = plxl
subject to
- wl(,yl+ + I+
y
(4 >
i1 i0--< 2+y1-x2
r2(i,
p2, w2)
(3I)
is
(A 3)
O, Yi > o, xI > o),
but where additional constraints on either or both xl or 11 and hence on y,

can arise depending upon whether the firm is rationed or not.
It is easily shown that behaviour in the four constraint regimes is as follows
(in the absence of corner solutions):
Unrationed.
Optimal inventory holdings are given by il = (P2-PI)/( cP2) and
optimal production Yi = (P1- wl,)/wl. Hence unrationed supply in (33) is
X1 =
io-__iCi2+
(P1-
W1t)/Wl + (Pl -P2)/Q(p2)
(A 4)
and unrationed labour demand in (33) is
11=
ft(p1-Ww1f) /W1 + 2[(pP1-w1t) /w1]2.

(A 5)
820
THE
ECONOMIC
JOURNAL
[DECEMBER
Labourrationed.Optimal inventory holdings are again given by il = (P2 -P1)/

but production is constrained to yl(ll), since labour is rationed. Hence
+ (p1-p2)/Qxp2),
X1 = io(A 6)
0_ij2+Yi(j)
where, for the labour constraint to be binding, 11 is below the level which
(A 5) says would have been demanded in the absence of the ration.
Sales rationed.It can be shown that optimal production is given by
(p2),
Y= {P2[I + a1 - aco + (a2/2)
io]-wl}/(w1
+p2x)
from which sales rationed labour (35) can be computed through 11 = /Y + 2y2
The resulting function and (A 6) are easily seen to give something like Fig. 4.
Note that for the sales constraint to be binding, xl is below the level which
(A 4) says would have been supplied in the absence of rationing.
Rationed both in sales and labour. If given the sales ration, the labour ration is
effective (less than the sales-rationed labour demand), and if given the labour
ration, the sales ration is effective (less than the labour-rationed supply of
goods), then the firm is rationed doubly. Inventories are then given by
il=j
1'2 + l (7 ) _j
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Macroeconomic Models with Quantity Rationing

Author(s): John Muellbauer and Richard Portes

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The EconomicJournal, 88 (DecemberI978), 788-82I

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assumptions; see Arrow and Hahn, I 97

But if there is no tdtonnementon prices and transactions take place at prices

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of parameter changes and poli4ies) in the manner of Malinvaud

a point of departure for empirically implementable models which will allow

A market is a trading post at which a non-monetary commodity exchanges for

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maximising utility (profit) subject to given initial endowments (technology)

An equilibrium with quantity rationing must satisfy certain conditions (see

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This content downloaded from 141.35.29.18 on Sun, 8 Feb 2015 09:48:57 AM

hufvud, I968; Hines,

flow of output (production) per period

Superscripts d and s denote demand and supply, h and f denote households

Amf 7Tt--dt = ptxt-wtlt-d

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to the money balances of the public.' With transfer payments to households

min (l, Is).

(sellers rationed in both markets)

> Is, so that

(buyers rationed in both markets)

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(buyers rationed in goods market, sellers rationed in labour market)

> Is, so that

(sellers rationed in goods market, buyers rationed in labour market).

The textbook income-expenditure

F-g. 2. Fig. I in consumption-labour space.

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U(.) is assumed to be increasingin all four argumentsand ct > , Tt > t -> o.

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=-U{c,, T, -11, c2 [(ml + d2)/P2, w2/P2, C1DT1- l}l

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where 6 depends at least on pl, w, and the level of dividend or transferpayments

where exogenous dividends or transfer payments d1 have been absorbed in

= V(cl, T1-11, mo+wlll-plcl,

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Suppose labour is rationed through 11 < 11 as illustrated in Fig. 3 by the

11 = 11 < 1s(AH) = 11(

11 = Is(AH, cO) = ls, d

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& < Cd(AH, 11) = C1.

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0 < h2(i1) +Y2 - x2.

Again, three regimes can arise in period 2: no rationing either of sales or of

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(fl(7TO) +E{ff2 [1T2(i1,

The expected value of transformed profits in period 2 will be a weighted

conditioning variables)]} - f * (il, 11,xl, 3f),

where 34 is a parameter vector which reflects those parts of the probabilistic

(il _ o, y1 > o, xi > o).

Substituting the constraint into the objective function allows UF to be expressed

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s(AF, 11) = xlD

Fig. 4. The firm's labour-rationed supply function

< xS(AF, 11) = xl.J

As indicated, the respective functions (33)-(36) represent the effective supply

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We must now aggregate the behavioural functions of individual households