Why short-run aggregate supply slopes upwards

Overview

Aggregate supply and describe the short-run aggregate supply curve, profit-margin reason why short-run aggregate supply slopes upwards and short-run aggregate supply curve become steeper as real output rises.

What you need to know

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Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Define aggregate supply and describe the short-run aggregate supply curve, naming both axes.

   Model answer

   Aggregate supply is the total quantity of goods and services that firms in an economy are willing and able to produce at each general price level in a given period. The short-run aggregate supply curve is drawn with the general price level on the vertical axis and real national output on the horizontal axis, and slopes upwards from left to right. A higher general price level is therefore associated with a larger real output supplied, provided the prices of inputs have not yet adjusted.

2. 2

   Explain the profit-margin reason why short-run aggregate supply slopes upwards.

   Model answer

   In the short run many input prices are fixed by contract: wages are set for a year or more, rents and leases are agreed in advance and materials may be bought forward. If the general price level rises while these costs stay put, the price a firm receives for its output rises relative to the cost of producing it, so the profit on each extra unit increases. Firms respond by raising output, taking on overtime and additional shifts, so a higher price level brings forth a larger real output.

3. 3

   How do rising marginal costs at high levels of capacity contribute to the upward slope of short-run aggregate supply?

   Model answer

   As output expands towards the limits of existing capacity, firms have to use their least efficient machines, pay overtime rates, hire less suitable workers and pay more to secure scarce materials, so the cost of producing each extra unit rises. Firms will only accept those higher costs if the price they receive rises too. A higher general price level is therefore needed to call forth a larger real output, which is what gives the curve its positive slope.

4. 4

   Why is the stickiness of money wages central to the short-run aggregate supply curve?

   Model answer

   Wages are the largest single cost for most firms, and they are typically fixed for a period by contracts, pay settlements and the practical difficulty of renegotiating frequently. While money wages are fixed, a rise in the general price level lowers the real cost of labour to the firm, making extra production profitable. If money wages instead adjusted instantly to every price change, real costs would never fall and there would be no reason for output to respond to the price level at all.

5. 5

   How can a misperception of prices by workers help produce an upward-sloping short-run aggregate supply curve?

   Model answer

   Workers observe the money wage they are offered immediately, but learn about the general price level only with a delay. When prices rise, a higher money wage can be mistaken for a higher real wage, so more labour is willingly supplied and firms can expand output. Once workers realise that prices have risen as much as their pay, the extra labour supply is withdrawn. The response therefore holds only in the short run, which is exactly the period the short-run curve describes.

6. 6

   What distinguishes the short run from the long run in aggregate supply analysis?

   Model answer

   The short run is the period during which at least one input price, most importantly the money wage, has not yet adjusted to a change in the general price level. The long run is the period after all input prices have fully adjusted, so that real costs are back where they started. Because of that difference, output responds to the price level in the short run but is determined by the quantity and productivity of the factors of production in the long run.

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