Transcript Aggregate S&D
Aggregate Demand & Supply Part II: Supply
Aggregate Supply
Aggregate Supply = total goods & services supplied
Aggregate Supply Curve
relates total goods & services supplied to general price level, Y = f(P)
disagreement over derivation
disagreement over shape
Theorists distinguish between short run and long run aggregate supply curves
Aggregate S
s
i
Just as the aggregate demand curve is not equal to the sum of individual demand curves, so too with supply
Individual supply curves are based on ceteris paribus assumption
But with general rise in price level, all prices rise, including input prices so ceteris paribus can't hold
Aggregate Supply = Results
So, aggregate supply is not really derived, it is presented as what happens on the whole, the net result of all firms responses to average changes in the price level
Yet, reasoning about the shape of the aggregate supply curve is carried on in terms of the way firms might be expected to act in various situations --based on microeconomic theory about firm decision making
Firm Theory
Microeconomic theory of the firm, says firms:
maximize net revenue or profit
rising input prices shift cost curves up and (ceteris paribus) reduce supply
falling input prices shift cost curves down and (ceteris paribus) increase supply
Let's look at an example:
Perfectly Competitive Firm - I
Output prices are given, max
w/ MC = MR MC price AC p 1 Q 1 Output
given price=
MR
Perfectly Competitive Firm - II
If costs fall, output will rise, with MC' = MR price MC MC' p 1 Q 1 Q 2 Output
Note: no change in given price!
Perfectly Competitive Firm - III
If Output prices rise, output rises MC price AC p 2 p 1
P=
MR Q 1 Q 2 Output
Contradiction
Note, reasoning about aggregate supply relates general price changes to output decisions
But:
FALLING input prices result in increased output
RISING output prices result in increased output
Solution?
Consider response of firms to overall price level
what this means is by no means clear, not in micro theory
Consider firms' short run capacity
in micro terms this is shape of cost curve
Consider lags between increases in overall price level and inputs, especially wages(!)
Clearly, the reasoning is only partially based on microeconomic firm theory
Positive Slope?
In general, it is assumed that in the short run firms will INCREASE output as the price level rises but with increasing difficulty as they approach their capacity (i.e., costs increase) determined by fixed production assets
Because we are dealing with aggregates, capacity is related, as in Keynesian theory, to "full employment" level of Y
Aggregate Supply Curve
So, aggregate supply is assumed to look like this: AS P Y
Changing slope?
At low levels of Y, AS is assumed to be relatively flat AS P
excess capacity rationale: easy to increase output, input prices lag, esp. wages Y
Changing slope?
At higher levels of Y, AS is assumed to be relatively vertical P AS
less excess capacity rationale: harder to
output as input prices
, esp. wages Y
Wage - Price Relation
A central issue here is the relationship between changes in prices and changes in wages
do wage changes lag price changes?
do wage changes keep up with price changes?
e.g., indexed wages?
if prices & wages adjust the same, then profit maximization would result in no change in output, --AS would be vertical
because ALL wages are almost never indexed, some will fall behind and rising prices will increase profits and result in higher output, e.g., upward slope
Shifts in AS curve
Anything that changes price - output decisions will shift curve P AS Y
Cost Shocks
Changes in basic costs, e.g., wages or oil, change costs for most firms P AS
wages
costs
AS
oil price
costs
AS Y
Growth & Stagnation
Changes in available means of production, eg., labor or capital shifts AS P AS
labor
capacity
AS
capital
capacity
AS Y
Public Policies
Policies that increase or decrease costs shift AS P AS
EPA
costs
AS
regulation
costs
AS Y