Download The Short Run Aggregate Supply Curve Page 1 of 2

Aggregate Demand/Aggregate Supply Model
Aggregate Supply
The Short Run Aggregate Supply Curve
Page 1 of 2
We are building a model of the macroeconomy because we want to explain the business cycle. We want to see what
influences the output and employment. We would also like to see if changes in policy could increase our standard of
living.
So, in an attempt to build a model, we started with an aggregate demand curve. This is the main axis of our model. It
shows the relationship between the aggregate price level, that is the price of all goods and services taken together,
and real gross domestic product, the output of the economy.
Now, you might think the next thing we are going to do is slap an aggregate supply curve in here and get an
equilibrium, but we have run into a problem. That is, while economists are pretty much in agreement about the
aggregate demand curve, how spending works, the way that the price level is related to output on the supply side is
controversial. In fact, there are all kinds of different theories about the aggregate supply curve. This is where
economists are most likely to disagree.
We start with a basic problem with aggregate supply and prices. That is this: why should the aggregate price level
affect the behavior of producers at all? After all, what producers really care about are profits, and profits depend upon
their revenues and their costs. So, if the aggregate price level is rising, then the prices of all goods and services are
rising together. That is, the price of final goods and services like cars and airplanes, and raw materials like steel and
labor.
Now, the price of your goods determines your revenue. If goods prices go up, and sales remain constant, then
revenue increases. The prices of raw material and labor determine your costs. If the price of raw materials and labor
rises, if wages go up and input prices rise, and your input quantities remain constant, then your costs are going to go
up. If revenues and costs are going up at the same rate, then your real profit is not changed at all. If your profit
opportunities remain unchanged, then why would the firm change its behavior? Why would it increase or decrease its
output?
Now in the long run, that is, after enough time has passed, an increase in the aggregate price level means that the
prices of all these goods have increased together, whether it is the final goods or the inputs, but in the short-run, that
is, during the period of adjustment, labor prices may increase faster than raw material prices, goods prices may
increase faster than labor. That is, these prices are not going to move upward adjusting in a constant smooth rate.
The adjustment is going to be jerky, kind of like traffic on a highway. Sometimes labor is going to pass raw materials.
Sometimes goods prices are going to pull ahead of them all.
It is this misalignment of prices; it is the difference in the rate of adjustment that creates opportunities for profits in the
short-run. That is, there is a period of time that may not persist very long, during which businesses can take
advantage of the fact that goods prices are rising faster than labor or raw materials.
One example would be if there are labor contracts that fix wages. If the prices of goods go up when labor costs are
fixed, then you have a profit opportunity and firms are going to increase their output. What if raw materials prices
were fixed by law or by some kind of agreement? What if the price of airline tickets rose relative to the price of
automobile rides in the short-run? People would do substitution, the way we describe in microeconomics.
What I am going to do now is use this insight that prices adjusting at different rates, creates opportunity for profit. I am
going to use that insight to derive the short-run aggregate supply curve. The short-run aggregate supply curve shows
the relationship between the aggregate price level and output in the economy in the short-run. The short-run is going
to be a period before all prices have reached their final adjustment. If I say that the price level goes up from a level of
100 up to a level of 110. If I say that, the price level in the economy has increased by 10 percent. In the short-run, the
price of automobiles may be increasing faster getting to that new target than the price of labor. It takes a while for
prices to adjust, and some prices adjust faster than others do.
Now, there are two stories I can tell you abut the way in which prices adjust. The final story, which I will tell you later,
involves labor contracts. The first story about the adjustment in prices is about confusion. Suppose you are an
Aggregate Demand/Aggregate Supply Model
Aggregate Supply
The Short Run Aggregate Supply Curve
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automobile manufacturer, and you see that people are coming into your automobile dealership with more money to
pay for cars. That is, that they are offering to pay higher prices than before. The price of cars on your lot is being bid
up. Well, in the short-run, confusion is going to persist. You are not going to be sure whether there is just increase
demand for automobiles or whether there is general economy-wide inflation. Maybe everybody is willing to pay more
for everything because the money supply has increased or something. The price of all things, that is, automobiles,
airplane rides, and labor are rising together. In the short-run, however, you are confused because you do not see the
prices of these other things and you have to act from your one observation which is that the price of your good is
going up. What you are going to do then is you are probably going hedge your bets, imagining that there is at least a
possibility that your profit opportunities have improved and you will respond by increasing your output from y=0 to a
higher level of output y=1. So an increase in the general price level can lead businesses to increase their output
because of confusion. They are not sure whether it is increase demand for their individual product, which is a profit
opportunity, or whether it is economy-wide inflation which is not a profit opportunity. Since they are uncertain, they
respond anyway, their response leads to an increase in real gross domestic product, and that gives us an upward
sloping of the supply curve in the short-run. The aggregate supply curve in the short-run is upward sloping because of
confusion.
The second possibility is what we call the “sticky-price theory” or the “sticky-price explanation.” The “sticky-price
explanation” says this: that when the general price level is rising, not all firms are going to be able to raise their prices
immediately because it is costly to raise your prices. One cost might be the cost of printing a new menu. You want to
raise your prices because the demand is obviously strong; people are bringing in more cash to pay for your meals, but
it is going to cost money to print up new menus. So, in the meantime, you leave the menu just like it is. Or in your
grocery store, you may find that items are piling up on the shelves, but you do not want to go around and stamp them
all right now, you want to wait and see if this is going to persist, because it is costly to adjust your prices. Or some
businesses are afraid to raise their prices for fear of making their customers happy. Imagine what would happen then
if the general price level was falling. That is, if the price level falls from 110 down to 100 and most businesses are
quick to adjust their prices downwards, but some of them are slow because of the menu costs or because of some
other cost of changing their prices. If that is the case, then these businesses that do not adjust their prices downward
with the rest of the economy suddenly find that they are not competitive anymore. Their prices are too high, and
therefore the demand for their products is going to be cut back and, as a result, they are going to reduce their output
because nobody wants to buy their stuff because of the high price. Now, in the long run, they will eventually get their
price down to the market, but in the short-run, the cost of adjustment causes them to delay. The cost is that they sell
less, and the consequence is they produce less.
So, I just told you two reasons then why the short-run aggregate supply curve will slope upwards. One is because of
confusion between demand for your product and general economy-wide inflation and the second is because of the
cost of adjustment, the “sticky-price problem.”
Next, we are going to look at how labor contracts can give us the same upward sloping aggregate supply curve in the
short-run.