Aggregate Demand & Supply Part II: Supply

Aggregate Supply n Aggregate Supply = total goods & services supplied n Aggregate Supply Curve u relates total goods & services supplied to general price level, Y = f(P)   disagreement over derivation   disagreement over shape n Theorists distinguish between short run and long run aggregate supply curves

Aggregate S   s i n Just as the aggregate demand curve is not equal to the sum of individual demand curves, so too with supply n Individual supply curves are based on ceteris paribus assumption n But with general rise in price level, all prices rise, including input prices so ceteris paribus can't hold

Aggregate Supply = Results n 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 n 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 n Microeconomic theory of the firm, says firms: u maximize net revenue or profit u rising input prices shift cost curves up and (ceteris paribus) reduce supply u falling input prices shift cost curves down and (ceteris paribus) increase supply n Let's look at an example:

Perfectly Competitive Firm - I Output prices are given, max  w/ MC = MR Output prices are given, max  w/ MC = MR Output price p1p1 given price= MR AC MC Q1Q1

Perfectly Competitive Firm - II n If costs fall, output will rise, with MC' = MR Output price p1p1 no change in given price! MC Q1Q1 MC' Q2Q2 Note:

Perfectly Competitive Firm - III n If Output prices rise, output rises Output price p1p1 P=MR AC MC Q1Q1 p2p2 Q2Q2

Contradiction n Note, reasoning about aggregate supply relates general price changes to output decisions n But: u FALLING input prices result in increased output u RISING output prices result in increased output

Solution? n Consider response of firms to overall price level u what this means is by no means clear, not in micro theory n Consider firms' short run capacity u in micro terms this is shape of cost curve n Consider lags between increases in overall price level and inputs, especially wages(!) n Clearly, the reasoning is only partially based on microeconomic firm theory

Positive Slope? n 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 n Because we are dealing with aggregates, capacity is related, as in Keynesian theory, to "full employment" level of Y

Aggregate Supply Curve n So, aggregate supply is assumed to look like this: AS P Y

Changing slope? n At low levels of Y, AS is assumed to be relatively flat AS P Y rationale: easy to increase output, input prices lag, esp. wages  excess capacity

Changing slope? n At higher levels of Y, AS is assumed to be relatively vertical AS P Y rationale: harder to  output as input prices , esp. wages  less excess capacity

Wage - Price Relation n A central issue here is the relationship between changes in prices and changes in wages u do wage changes lag price changes? u do wage changes keep up with price changes? n e.g., indexed wages? n if prices & wages adjust the same, then profit maximization would result in no change in output, --AS would be vertical u 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 n Anything that changes price - output decisions will shift curve AS Y P

Cost Shocks n Changes in basic costs, e.g., wages or oil, change costs for most firms AS Y P  oil price  costs  AS  wages  costs  AS

Growth & Stagnation n Changes in available means of production, eg., labor or capital shifts AS AS Y P  capital  capacity  AS  labor  capacity  AS

Public Policies n Policies that increase or decrease costs shift AS AS Y P  regulation  costs  AS  EPA  costs  AS

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