Positive Slope of the Short-Run Aggregate Supply Curve
The short-run aggregate supply curve has a positive slope because the price level and aggregate supply have a positive relationship. This relationship is due to the rigidity of prices to adjust in the short run. To explain this price rigidity, the theories of sticky wages, sticky prices, and mistaken perceptions are presented. All of them share the commonality that people are surprised in the short run, but in the long run, they have the capacity to react and adapt appropriately.
Why Does the Price Level Affect Output in the Short Run?
The following theories are the most common when explaining why the price level affects output in the short run but not in the long run.
Sticky Wage Theory
Prices have an inability to adjust correctly in the short run; the best example is nominal wages, which adjust slowly to economic conditions. In other words, in the short run, they are rigid. The main reason is that most wages are fixed by contracts, often for a fixed term, so they do not change until a certain time and gradually adjust. The short-run macroeconomic theory proposes that this is one of the main reasons for the difference between the short run and the long run. Wages are set according to the expected price level, which often differs from the actual level. Consequently, employers or employees may benefit or be affected depending on whether the actual price level is below or above the expected level. However, in the long run, contracts expire, and wages adjust. This theory is known as the sticky wage theory.
Sticky Price Theory
Wages are not the only prices that adjust gradually in response to economic conditions; the prices of goods and services do as well. The reason is that there are costs associated with changing prices, called menu costs. These are costs such as printing and distributing price lists and the time required to do so, as well as the administrative costs of deciding on new prices. Consequently, prices are usually announced for set periods, which can even be annual. These announced prices are based on the expected price level. Depending on whether the actual price level is above or below the expected level, sales may benefit or be affected. Some companies and sellers have the ability to adapt quickly, but others take time to adjust. This theory of the difficulty of prices adjusting in the short run is known as the sticky price theory.
Mistaken Perceptions Theory
Changes in the general price level can temporarily lead suppliers to have mistaken perceptions of what is happening in the economy. Based on these mistaken perceptions, they respond to changes in the price level. When producers see the price level increase or decrease more than they expected, they may mistakenly assume that relative prices are changing and that the price of their product has increased or decreased accordingly, leading to a downward or upward adjustment in production. In both cases, the change in the price level is affecting production decisions. This theory is known as the mistaken perceptions theory, given that, for example, an increase in the price level may lead producers to think that the price of their product has increased and adjust their level of production, and thus the supply, even though what was actually increasing was the price level and not the real price of the product. The opposite is also true; whatever the case, this is corrected in the long run.
Differences Between Expected and Actual Price Levels
Production deviates in the short run from its natural level when the current price levels deviate from the price level that people expected, which can be represented as:
\[ \text{Aggregate Supply} = \text{Natural Level of Production} + a \left( \frac{\text{Current Price Level}}{\text{Expected Price Level}} \right) \]
In this equation:
- Aggregate Supply: Refers to the total quantity of goods and services that firms are willing to offer in the market at a given price level.
- Natural Level of Production: This is the level of production that an economy can sustain in the long run, given the efficient use of its resources and the available technology.
- Current Price Level: Represents the prevailing price level in the economy at a given moment. This level can fluctuate due to changes in aggregate demand, aggregate supply, and other economic factors.
- Expected Price Level: Refers to the expectations that economic agents have regarding the price level in the future. These expectations can influence production and consumption decisions.
- a: This parameter is a coefficient that measures the sensitivity of aggregate supply to changes in the price level. It indicates how a change in the price level affects the quantity of goods that firms are willing to produce.
This equation shows that aggregate supply not only depends on the natural level of production but also on the relationship between the current price level and the expected price level.
- When the current price level is greater than the expected price level (\(\text{Current Price Level} > \text{Expected Price Level}\)), the term \(a \left( \frac{\text{Current Price Level}}{\text{Expected Price Level}} \right)\) becomes positive. This indicates that firms are incentivized to increase their production, as they can obtain higher prices for their goods and services.
- When the current price level is less than the expected price level (\(\text{Current Price Level} < \text{Expected Price Level}\)), the term \(a \left( \frac{\text{Current Price Level}}{\text{Expected Price Level}} \right)\) becomes negative or less positive. This suggests that firms may reduce their production, as the current prices are not sufficient to cover their costs and meet profitability expectations.
In summary, when the price level is above the expected level, short-run aggregate supply increases, and conversely, when the price level is below the expected level, short-run aggregate supply decreases.
Conclusion
In conclusion, all these theories that seek to explain the positive relationship between the price level and aggregate supply in the short run are a market imperfection that causes different behavior in the short and long run. It can be summarized that economic agents are surprised in the short run; indeed, these theories suggest that production deviates in the short run from its long-term trend when price levels deviate from the price level that people expected. However, all of them express a problem that is temporary. In the long run, prices and wages are not rigid, and the mistaken perception of relative prices is corrected.