Adjustment Costs

The costs associated with making changes in economic variables controlled by economic agents.
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In one sentence

Adjustment costs are frictions that make it costly to change a choice variable quickly (prices, employment, capital, inventories), so optimal behavior features gradual adjustment and sometimes “lumpy” changes.

What adjustment costs look like

Examples include:

  • hiring and firing costs (recruiting, training, severance),
  • installing new capital (downtime, retooling, learning-by-doing),
  • changing prices (menu costs, re-tagging, coordination),
  • switching suppliers or technologies (search and conversion costs).

A simple representation (convex adjustment costs)

A common modeling choice is a convex cost of changing a variable, e.g., investment $I_t$ changes capital:

$$ K_{t+1} = (1-\delta)K_t + I_t $$

with an adjustment cost such as:

$$ \Phi(I_t, K_t) = \frac{\phi}{2}\left(\frac{I_t}{K_t} - \delta\right)^2 K_t $$

Convex costs imply that spreading adjustment over time can be cheaper than a one-shot change.

Fixed costs and “lumpy” adjustment

If there is a fixed cost to adjusting (e.g., paying a set-up cost to change a price), the optimal policy can become an $(s,S)$ rule:

  • do nothing while the gap is small,
  • adjust once the gap crosses a threshold.
    flowchart LR
	  A["Shock changes desired level"] --> B{"Is gap big enough?"}
	  B -- "No" --> C["Wait / partial adjustment"]
	  B -- "Yes" --> D["Pay adjustment cost"]
	  D --> E["Reset variable closer to target"]

Why adjustment costs matter in macro

Adjustment costs help explain:

  • slow responses of investment and employment to shocks,
  • price and wage stickiness (New Keynesian models),
  • persistent dynamics (hump-shaped responses) after monetary or technology shocks.
  • Menu Costs: The costs incurred by firms in changing the prices of their products.
  • Natural Wastage: Reductions in labor force achieved through retirements and voluntary departures rather than layoffs.
  • Redundancies: Layoffs of workers whose roles are no longer necessary, often associated with high social and financial costs.

Quiz

### Which economic agents face adjustment costs? - [x] Individuals, firms, and governments - [ ] Only firms - [ ] Only individuals - [ ] Only governments > **Explanation:** Adjustment costs apply to all economic agents, including individuals, firms, and governments. ### What drives the need for adjustment costs? - [ ] Market volatility - [x] The goal to reach optimal levels of control variables - [ ] Production constraints - [ ] Price inflation > **Explanation:** Adjustment costs come into play when economic agents aim to align actual variables with their optimal levels. ### What can gradual adjustment be attributed to? - [ ] Lower marginal costs in the short term - [x] Costs increasing more than proportionally to the size of change - [ ] A stable economy - [ ] Fixed costs > **Explanation:** If costs increase more than proportionally, gradual adjustments become optimal to mitigate high expenses. ### What is the difference between natural wastage and redundancies? - [x] Natural wastage is less costly, while redundancies involve high costs. - [ ] Redundancies are less costly. - [ ] Natural wastage applies only to equipment. - [ ] There is no difference. > **Explanation:** Natural wastage involves voluntary departures, making it less costly than forced redundancies which often include severance pay. ### Which of the following is a related term to adjustment costs? - [x] Menu Costs - [ ] Investment Costs - [ ] Variable Costs - [ ] Sunk Costs > **Explanation:** Menu costs, like adjustment costs, involve expenses for small changes specifically related to pricing. ### True or False: Adjustment costs only apply to increasing economic variables. - [ ] True - [x] False > **Explanation:** Adjustment costs apply to both increases and decreases in economic variables. ### What would be an example of adjustment costs in a business? - [x] Severance pay for laid-off employees - [ ] Office stationery expenses - [ ] Insurance premiums - [ ] Rent payments > **Explanation:** Severance pay is a particular instance of adjustment costs, incurred during workforce reduction. ### Why might a firm prefer natural wastage over redundancies? - [ ] Due to higher immediate costs of hiring - [ ] Due to market pressure - [ ] Due to regulatory requirements - [x] Due to lower associated costs and maintained morale > **Explanation:** Natural wastage allows gradual workforce reduction without high costs and negative morale impact. ### When might a firm opt for rapid adjustments despite higher adjustment costs? - [x] When the anticipated benefits outweigh the costs. - [ ] When gradual adjustment is feasible. - [ ] Under stable market conditions. - [ ] During inflation. > **Explanation:** Firms will incur higher immediate adjustment costs if the gains from quick changes are expected to exceed the expenses. ### How are menu costs different from adjustment costs? - [x] Menu costs pertain to changing prices. - [ ] Menu costs apply to all adjustments. - [ ] Menu costs are related to labor adjustments. - [ ] Menu costs involve technology shifts. > **Explanation:** Menu costs specifically refer to the expenses incurred in changing prices, a narrower scope than adjustment costs.
Adjustment Programme
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