### Aggregate Supply

```Aggregate Supply
The AS is the part of our national
economy model where the production
side is studied.
1
An Analogy and a definition
Which blade cuts the paper when you use a pair of scissors on
the paper?
The answer is that you need both to cut the paper.
Up to now in our theory about the national economy we have
both blades in the scissors, we also have to build in aggregate
supply into our theory.
Aggregate Supply AS is about the relationship between the
price level and the amount of real domestic output (RGDP)
that firms in the economy produce.
2
Recall an earlier story
production when prices were sticky and when they could freely
adjust. With sticky prices we saw a horizontal supply and with
flexible prices we saw a vertical supply.
In the larger, full economy we recall this earlier story and build on
it. In macro we will think about three scenarios:
1) Input prices and output prices are fixed, or are sticky,
2) Input prices are fixed but output prices can change, and
3) Both input prices and output prices can change.
Let’s explore each of these scenarios next.
3
The Immediate Short Run
Price level
P1
ASISR
75% of a typical firm’s costs
are wage and salary and
these are fixed either by
contract (like for me) or
there is an implicit
understanding that wages are
negotiated only every so
often (maybe yearly). A
good deal of input prices are
fixed in this time frame.
RGDP
4
The Immediate Short Run
Also in the immediate short run output prices are fixed. Firms
print up menus and price lists and in the very short term they
stick with these prices.
So, the immediate short run is anywhere from a few days to a
few months. The more important point is that it is that period of
time when both input prices and output prices are fixed
(sticky!).
Hey, try not to be confused by input prices and output prices.
Example: Say the output is pizza. The output price is the price
of the cooked pizza. What are the inputs to making pizza? The
dough, sauce and other ingredients are inputs that will have
prices, as will the labor that is making the pizza (and the price of
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labor is often called the wage!).
The Immediate Short Run
Price level
Low
Full
P1
High
ASISR
Low
Full
Note that the level of output
in this immediate short term
will depend on aggregate
demand and the RGDP level
that corresponds to full
employment will only occur
if demand is AD Full. In
other words the full
employment level of output
is not guaranteed in the
economy.
RGDP
High
6
Short Run
P
AS
P2
P1
RGDP1
RGDP2
The AS has an upward
slope to it as we view it
from left to right. This
means the price level and
the level of RGDP firms
will offer for sale is
positively, or directly,
related.
RGDP
7
Short Run
Note that the short run is defined here as the time frame in
which input prices are fixed but output prices can change.
Higher (lower) output prices with fixed input prices means
profits would be higher (lower) and this is the incentive
(disincentive) firms need to increase (decrease) real output.
On the last screen you can see that at low levels of RGDP the
AS is somewhat flat and as the level of RGDP rises the curve
is becomes steeper.
Let’s look at this next.
8
Per Unit Production Cost
In order to see the points about AS we need to think about the
following ratio:
Total input cost/units of output.
This ratio is the per unit production cost (on average) of output.
Ultimately the price per unit of output has to cover this or firms
would not be able to produce because they wouldn’t be making
any profit. The AS is a curve showing what price levels have to be
to get the various levels of output produced.
needed (but remember the short run has the input prices fixed!).
9
Per unit production cost
When output is already low, below the full employment level,
this means many resources are underutilized. To add output
resources that are idle get put back to work and the ratio of input
cost to output does not change much. So the price level does
not have to expand much to get more output. With the higher
price level firms have an incentive to produce more.
Now, when output is already at the full employment level of
output or above, additional output is that much harder to come
by. Adding inputs, when a great deal of output is already being
made does not yield as much output as before and thus per unit
costs rise. In order to get the additions, the price level would
10
Long run
P
ASLR
P2
P1
Given a state of technology
and resource endowments the
ASLR is shown as one level of
RGDP. This is the full
employment level of output
in the economy. Since it is a
vertical line, we see that if
the price level should change
the quantity supplied in the
long run will not change.
RGDP
RGDP1
11
Long Run
The long run is defined as the time frame in which both input
prices and output prices can change.
Say that the economy is really producing a great deal of
output. When the economy is operating at a high level
workers are often putting in a lot of overtime because there
are few excess workers and other resources. After a while
workers and other resource owners conclude that input prices
need to adjust because of this work pattern. Higher output
prices resulting from high levels of output soon get matched
with higher input prices. Output then stays at the potential
level in the economy.
12
Summary up to Now
The immediate short run aggregate supply is referred to as ASISR and is
the result of both input and output prices being fixed.
The short run aggregate supply is referred to as AS and is the result of
input prices being fixed but output prices as being flexible.
The long run aggregate supply is referred to as ASLR and is the result of
both input and output prices being flexible.
The authors note that a great deal of our time will focus on the short
run and unless otherwise stated that will be the context of the
discussion of aggregate supply for now. The reason for this is because
business cycles are thought to have the same conditions as under13the
short run – namely flexible output prices, inflexible input prices.
There are 3 kinds of people in the world. There are those who can
count and those who can’t !
Shifting AS
The AS supply curve can shift if we have a change in
2) productivity, 3) business taxes and subsidies, and 4) government
regulation. Let’s look at each idea here next.
If productivity grows then firms can make available for sale a greater
number of goods available for sale at each price level – The AS shifts
to the right.
When business taxes grow, or when subsidies fall, firms have to pay
out a greater amount from the price level they receive and therefore
they keep less. The fact that they keep less makes them more reluctant
to supply and thus AS shifts to the left.
Government regulation is usually costly for the firm to cover and so
14
more regulations reduce AS and this means the curve shifts to the left.
Shifting AS
The AS supply curve can shift if we have a change in
1) Input prices – WAIT A MINUTE – before we said input prices
were fixed in the short run! What is up? The real story is that as
the long run is approached input prices change and this will cause a
shift in the short run AS. Plus there are shocks on the supply side
that cause inputs prices to change.
If input or resources prices rise, then per unit production costs rise
and thus at the same price level firms in total would reduce output
and AS would shift to the left.
Note some inputs in US economy actually come from other
countries. So, if the dollar becomes weaker foreign inputs get more
expensive because we need more dollars to get a unit of foreign15
currency.
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