The model of this paper generalizes the classical theory of consumer behavior to the more general case of prices that are not necessarily market-clearing. Suppose that, in addition to the money cost, some sort of search, waiting, or other quasi-fixed "effort-cost" is needed to obtain goods. The presence of this quasi-fixed cost element will trigger an inventory policy. A shortage equilibrium occurs when effort costs are such that, in the corresponding inventory policy, the flow of desired consumption does not exceed the available supply flow. Stock hoarding, a critical phenomenon in the economics of shortage, emerges as a natural component of this model. A complete characterization of a stationary shortage equilibrium is given. Comparative statics and welfare analysis are performed. The dynamic transition between steady states is analyzed to give insight into the mechanics of how shortages develop.

The model of this paper generalizes the classical theory of consumer behavior to the more general case of prices that are not necessarily market-clearing. Suppose that, in addition to the money cost, some sort of search, waiting, or other quasi-fixed "effort cost" is needed to obtain goods. The presence of this quasi-fixed cost element will trigger an inventory policy. A shortage equilibrium occurs when effort costs are such that, in the corresponding inventory policy, the flow of desired consumption does not exceed the available supply flow. Stock hoarding, a critical phenomenon in the economics of shortage, emerges as a natural component of this model. A complete characterization of a stationary shortage equilibrium is given. Comparative statics and welfare analysis are performed. The dynamic transition between steady states is analyzed to give insight into the mechanics of how shortages develop. Copyright 1991 by American Economic Association.

When Keynes came to sum up the central message of the General Theory for the economics profession, in a remarkable but by now long-forgotten QJE article of 1937, he began with a philosophical disquisition on the behavior of mankindunder uncertainty. Here as elsewhere, Keynes made it abundantly clear that he shared Frank Knight's distinction. Uncertainty did not mean risk-that which is, at least in principle, reducible to well-defined actuarial probabilities. By uncertainty Keynes intended, I believe, to convey the idea of ignorance-that which is essentially due to insufficient or precarious knowledge of the mechanism by which the future is generated out of the past. The Keynesian scenario looks out over an economic world that is rife with uncertainty. In that world, expectations play an important dual role as both a manifestation of uncertainty and a cause of it. Such expectations are arbitrary to some degree because they can be based on almost anything, including self-fulfilling expectations of the behavior and expectations of others. And, as Keynes pointed out, based on so flimsy a foundation, these expectations of expectations are subject to sudden and violent changes. It follows that while there may ultimately be some long-run forces drawing it toward full employment, capitalism may also have some deep-seated tendencies toward shortrun instability. Unadulterated laissez-faire is likely to be out of equilibrium much of the time, and even when it is in equilibrium there is no guarantee of being in a equilibrium. Whether in a state of bad equilibrium or merely in disequilibrium, such coordination failures generate undesirable macroeconomic consequences like unemployment which can cause very significant welfare losses. By the ultimate logic of this Keynesian worldview, then, the stage is set for some form of government intervention to recoordinate the economy into a better configuration. Any such government policy will inevitably introduce some microeconomic distortions, but as an empirical matter such losses tend to be small, relative to the enormous welfare gains from having an economy operate at its full-employment level. Such general considerations do not indicate the best form of government intervention to stabilize the macroeconomy. Indeed, we do not currently have a general, realistic framework within which a meta-issue like that might be properly addressed. Nevertheless it is possible, I believe, to give some common sense criteria for desirable forms of government intervention. It is my contention that economists have not been sufficiently imaginative in devising operational mechanisms or systems possessing advantageous macroeconomic properties. The usual fiscal and monetary policies are, to my mind, sledgehammer-like tactics for controlling unemployment and inflation. They do the job, but clumsily, by brute force-and they can leave a big mess afterwards. I think it is possible to find subtler alternatives that operate more cleanly and with a softer touch by taking a page from the book of Adam Smith. A good mechanism for fighting unemployment and inflation should have several noteworthy characteristics. It should be decentralized, based on the natural microeconomic incentives of a market-like environment. It should work more or less automatically, keeping to a minimum the need for using discretionary government policy. And, in a highly uncertain world, it should be robust in retaining its desirable macroeconomic characteristics over a wide range of possible situations or circumstances-including some that are currently unforseen. I want to argue that a superior form of government policy for combating unemploy*Department of Economics, Massachusetts Institute of Technology, Cambridge, MA 02139.

A situation traditionally identified conducive to imperfect competition is when average costs decline and the cheapest scale of production is large relative to the size of the market. However, some of the more recent literature on industrial organization has emphasized supposed distinction between fixed costs of production and sunk costs of production. A point frequently made is that while the possibility of sunk costs can create genuine barriers to entry, fixed costs per se do not inhibit competitive market performance. This approach finds its logical extreme in the norm or abstraction of perfect contestability. Perfect contestability is essentially theory of the polar case of frictionless entry and exit. As William Baumol stated, a contestable market is one into which entry is absolutely free and exit is absolutely costless (p. 3). Certainly this is the most reasonable interpretation of situation where potential entrants feel free to disregard an incumbent's price response. Suppose every potential and actual producer has access to the same technology. In perfectly contestable market, there are no set-up or shut-down losses. The main result is that even with declining average costs of production, the incumbent firm does not dare to post price higher than average cost. Price above cost invites being undercut by hit-and-run shadow entrant capable of producing at the same flow rate and at identical unit cost during just the briefest instant of time. I argue that this line of reasoning is misleading. Perfect contestability gets around the problem of increasing returns only by, in effect, assuming it away. A hit-and-run technology makes the firm behave as if it is competitive in market precisely because the convexity preconditions for competition are de facto being met in that market. This comment shows that, strictly speaking, there is no such thing pure fixed cost. Unless there are sunk costs located somewhere in the relevant production technology, all costs are variable. As matter of formal theory, you cannot have range of decreasing average cost without sunk costs. Presumably there is also an approximation theorem which states that when sunk costs are close to being negligible then average production costs are practically nondecreasing. Perfect contestability holds approximately in market only to the extent that production costs for the market are approximately nondecreasing. My discussion will be restricted to the familiar case of single, well-defined, homogeneous, fully divisible commodity. While more general approaches are possible, for the sake of simplicity the following definition is used. The average cost function A C(y, t) describes, say, the minimum cost per unit of output produced at uniform flow rate y throughout the time interval (0, t]. Especially in applications to industrial organization theory it is essential to remember that cost functions are not generally timeless, and that writing AC function of y alone can be dangerously vague. Behind the free entry and exit of hitand-run technology in perfectly contestable market is the abstraction of no sunk costs-investments are fully reversible because nothing is lost in setting up or shutting down production.

The author determines which revenue schedule, when applied by economic regulation to production units, will result in an optimum response. He points out that regulations must be stable for a long-enough period to be taken seriously by a firm, although they should not be considered to be immutable, and that good regulatory strategy encourages cheap firms to produce more and expensive firms to produce less. A model framework is described for determining optimal revenue function and the various dependency factors are characterized. Two components, the traditional price signal and a penalty for departure from the quantity target, comprise the optimal reward function, which means that it is not redundant for economic planners to set both prices and production quotas. This analysis can be applied to environmental economics in terms of effluent standards.