Aggregate Demand & SupplyPart II: Supply

Aggregate Demand & SupplyPart II: Supply

Aggregate SupplyAggregate Supply

Aggregate Supply = total goods & services Aggregate Supply = total goods & services suppliedsupplied

Aggregate Supply CurveAggregate Supply Curve relates total goods & services supplied to general relates total goods & services supplied to general

price level, Y = f(P)price level, Y = f(P) disagreement over derivationdisagreement over derivation disagreement over shapedisagreement over shape

Theorists distinguish between short run and Theorists distinguish between short run and long run aggregate supply curveslong run aggregate supply curves

Aggregate S siAggregate S si

Just as the aggregate demand curve is not equal Just as the aggregate demand curve is not equal to the sum of individual demand curves, so too to the sum of individual demand curves, so too with supplywith supply

Individual supply curves are based on Individual supply curves are based on ceteris ceteris paribus paribus assumptionassumption

But with general rise in price level, all prices But with general rise in price level, all prices rise, including input prices so rise, including input prices so ceteris paribus ceteris paribus can't holdcan't hold

Aggregate Supply = ResultsAggregate Supply = Results

So, aggregate supply is not really So, aggregate supply is not really derivedderived, it is , it is presented as presented as what happens what happens on the whole, the net on the whole, the net result result of all firms responses to average changes of all firms responses to average changes in the price levelin the price level

Yet, reasoning about the shape of the aggregate Yet, reasoning about the shape of the aggregate supply curve is carried on in terms of the way supply curve is carried on in terms of the way firms might be expected to act in various firms might be expected to act in various situations --based on microeconomic theory situations --based on microeconomic theory about firm decision makingabout firm decision making

Firm TheoryFirm Theory

Microeconomic theory of the firm, says firms:Microeconomic theory of the firm, says firms: maximize net revenue or profitmaximize net revenue or profit rising input prices shift cost curves up and (ceteris rising input prices shift cost curves up and (ceteris

paribus) reduce supplyparibus) reduce supply falling input prices shift cost curves down and falling input prices shift cost curves down and

(ceteris paribus) increase supply(ceteris paribus) increase supply

Let's look at an example:Let's look at an example:

Perfectly Competitive Firm - IPerfectly Competitive Firm - I Output prices are given, max Output prices are given, max w/ MC = MR w/ MC = MR

Output

price

p1 givenprice=MR

AC

MC

Q1

Perfectly Competitive Firm - IIPerfectly Competitive Firm - II

If costs fall, output will rise, with MC' = MRIf costs fall, output will rise, with MC' = MR

Output

price

p1no changein givenprice!

MC

Q1

MC'

Q2

Note:

Perfectly Competitive Firm - IIIPerfectly Competitive Firm - III If Output prices rise, output risesIf Output prices rise, output rises

Output

price

p1 P=MR

AC

MC

Q1

p2

Q2

ContradictionContradiction

Note, reasoning about aggregate supply relates Note, reasoning about aggregate supply relates general price changes to output decisionsgeneral price changes to output decisions

But:But: FALLING input prices result in increased outputFALLING input prices result in increased output RISING output prices result in increased outputRISING output prices result in increased output

Solution?Solution?

Consider response of firms to overall price levelConsider response of firms to overall price level what this means is by no means clear, not in micro what this means is by no means clear, not in micro

theorytheory

Consider firms' short run capacityConsider firms' short run capacity in micro terms this is shape of cost curvein micro terms this is shape of cost curve

Consider lags between increases in overall price Consider lags between increases in overall price level and inputs, especially wages(!)level and inputs, especially wages(!)

Clearly, the reasoning is only partially based on Clearly, the reasoning is only partially based on microeconomic firm theorymicroeconomic firm theory

Positive Slope?Positive Slope?

In general, it is assumed that in the short run In general, it is assumed that in the short run firms will INCREASE output as the price level firms will INCREASE output as the price level rises but with increasing difficulty as they rises but with increasing difficulty as they approach their capacity (i.e., costs increase) approach their capacity (i.e., costs increase) determined by fixed production assetsdetermined by fixed production assets

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

Aggregate Supply CurveAggregate Supply Curve

So, aggregate supply is assumed to look like So, aggregate supply is assumed to look like this:this:

ASP

Y

Changing slope?Changing slope?

At low levels of Y, AS is assumed to be At low levels of Y, AS is assumed to be relatively flatrelatively flat

ASP

Y

rationale: easy toincrease output,input prices lag,esp. wages

excesscapacity

Changing slope?Changing slope?

At higher levels of Y, AS is assumed to be At higher levels of Y, AS is assumed to be relatively verticalrelatively vertical

ASP

Y

rationale: hardertooutput asinput prices ,esp. wages

less excesscapacity

Wage - Price RelationWage - Price Relation

A central issue here is the relationship between A central issue here is the relationship between changes in prices and changes in wageschanges in prices and changes in wages do wage changes lag price changes?do wage changes lag price changes? do wage changes keep up with price changes?do wage changes keep up with price changes?

e.g., indexed wages?e.g., indexed wages? if prices & wages adjust the same, then profit if prices & wages adjust the same, then profit

maximization would result in no change in output, --AS maximization would result in no change in output, --AS would be verticalwould be vertical

because ALL wages are almost never indexed, some because ALL wages are almost never indexed, some will fall behind and rising prices will increase profits will fall behind and rising prices will increase profits and result in higher output, e.g., upward slopeand result in higher output, e.g., upward slope

Shifts in AS curveShifts in AS curve

Anything that changes price - output Anything that changes price - output decisions will shift curvedecisions will shift curve

AS

Y

P

Cost ShocksCost Shocks Changes in basic costs, e.g., wages or oil, Changes in basic costs, e.g., wages or oil,

change costs for most firmschange costs for most firms

AS

Y

P

oil pricecostsAS

wagescostsAS

Growth & StagnationGrowth & Stagnation Changes in available means of Changes in available means of

production, eg., labor or capital shifts ASproduction, eg., labor or capital shifts AS

AS

Y

P

capitalcapacity

AS

laborcapacity

AS

Public PoliciesPublic Policies Policies that increase or decrease costs Policies that increase or decrease costs

shift ASshift AS

AS

Y

P

regulationcostsAS

EPAcostsAS

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