The Aggregate-Supply Curve
Why the Aggregate-Supply Curve Slopes Upward in the Short Run
The key difference between the economy in the short run and in the long run is the behavior of aggregate supply.
The long-run aggregate-supply curve is vertical because, in the long run, the overall level of prices does not affect the economy’s ability to produce goods and services. By contrast, in the short run, the price level does affect the economy’s output.
That is, over a period of a year or two, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied, and a decrease in the level of prices tends to reduce the quantity of goods and services supplied.
As a result, the short-run aggregate-supply curve slopes upward, as shown in Figure I.
Why do changes in the price level affect output in the short run?
Macroeconomists have proposed three theories for the upward slope of the short-run aggregate-supply curve. In each theory, a specific market imperfection causes the supply side of the economy to behave differently in the short run than it does in the long run.
The following theories differ in their details, but they share a common theme: The quantity of output supplied deviates from its long-run, or natural, level when the actual price level in the economy deviates from the price level that people expected to prevail.
When price level rises above the level that people expected, output rises above its natural level, and when the price level falls below the expected level, output falls below its natural level.
The Sticky-Wage Theory
The first explanation of the upward slope of the short-run aggregate-supply curve is the sticky-wage theory.
This theory is the simplest of the three approaches to aggregate supply, and some economists believe it highlights the most important reason why the economy in the short run differs from the economy in the long run. Therefore, it is the theory of short-run aggregate supply that we emphasize in the series.
According to the sticky-wage theory, the short-run aggregate-supply curve slopes upward because nominal wages are slow to adjust to changing economic conditions. In other words, wages are “sticky” in the short run.
To some extent, the show adjustment of nominal wages is attributable to long-term contracts between workers and firms that fix nominal wages, sometimes for as long as 3 years. In addition, this prolonged adjustment may be attributable to slowly changing social norms and notions of fairness that influence wage setting.
An example can help explain how sticky nominal wages can result in a short-run aggregate-supply curve that slopes upward. Imagine that a year ago a firm expected the price level today to be 100, and based on this expectation, it signed a contract with its workers agreeing to pay them, say, $20 an hour. In fact, the price level turns out to be only 95.
- Because prices have fallen below expectations, the firm gets 5 percent less than expected for each unit of its product that it sells.
- The cost of labor used to make the output, however, is stuck at $20 per hour.
- Production is now less profitable, so the firm hires fewer workers and reduces the quantity of output supplied.
Over time, the labor contracts will expire, and the firm can negotiate with its workers for a lower wage (which they may accept because prices are lower), but in the meantime, employment and production will remain below their long-run levels.
The same logic works in reverse.
Suppose the price level turns out to be 105 and the wage remains stuck at $20. The firm sees that the amount it is paid for each unit sold is up by 5 percent, while its labor costs are not. In response, it hires more workers and increases the quantity of output supplied.
Eventually, the workers will demand higher nominal wages to compensate for the higher price level, but for a while, the firm can take advantage of the profit opportunity by increasing employment and production above their long-run levels.
In short, according to the sticky-wage theory, the short-run aggregate-supply curve slopes upward because nominal wages are based on expected prices and do not respond immediately when the actual level turns out to be different from what was expected.
This stickiness of wages gives firms an incentive to produce less output when the price level turns out lower than expected and to produce more when the price level turns out higher than expected.
The Sticky-Price Theory
Some economists have advocated another approach to explaining the upward slope of the short-run aggregate-supply curve, called the sticky-price theory. As we just discussed, the sticky-wage theory emphasizes that nominal wages adjust slowly over time.
The sticky-price theory emphasizes that the prices of some goods and services also adjust sluggishly in response to changing economic conditions.
This slow adjustment of prices occurs in part because there are costs to adjusting prices, called menu costs. These menu costs include the cost of printing and distributing catalogs and the time required to change price tags. As a result of these costs, prices as well as wages may be sticky in the short run.To see how sticky prices explain the aggregate-supply curve’s upward slope:
- Suppose that each firm in the economy announces its prices in advance based on the economic conditions it expects to prevail over the coming year.
- Suppose further that after prices are announced, the economy experiences an unexpected contraction in the money supply, which (as we have learned) will reduce the overall price level in the long run.
What happens in the short run?
Although some firms reduce their prices quickly in response to the unexpected change in economic conditions, many other firms want to avoid additional menu costs. As a result, they temporarily lag behind in cutting their prices.
Because these lagging firms have prices that are too high, their sales decline. Declining sales, in turn, cause these firms to cut back on production and employment.
In other words, because not all prices adjust immediately to changing conditions, an unexpected fall in the price level leaves some firms with higher-than-desired prices, and these higher-than-desired prices depress sales and induce firms to reduce the quantity of goods and services they produce.Similar reasoning applies when the money supply and price level turn out to be above what firms expected when they originally set their prices.
While some firms raise their prices quickly in response to the new economic environment, other firms lag behind, keeping their prices at the lower-than-desired levels.
These low prices attract customers, which induces these firms to increase employment and production.
Thus, during the time these laggings firms are operating with outdated prices, there is a positive association between the overall price level and the quantity of output. This positive association is represented by the upward slope of the short-run aggregate-supply curve.
The Misperceptions Theory
A third approach to explaining the upward slope of the short-run aggregate-supply curve is the misperceptions theory.
According to the misperceptions theory, changes in the overall price level can temporarily mislead suppliers about what is happening in the individual markets in which they sell their output.
As a result of these short-run misperceptions, suppliers respond to changes in the level of prices, and this response leads to an upward-sloping aggregate-supply curve.
To see how this might work, suppose the overall price level falls below the level that suppliers expected.
When suppliers see the prices of their products fall, they may mistakenly believe that their relative prices have fallen; that is, they may believe that their prices have fallen compared to other prices Opens in new window in the economy Opens in new window.
For example, wheat farmers may notice a fall in the price of wheat before they notice a fall in the prices of the many items they buy as consumers. They may infer from this observation that the reward for producing wheat is temporarily low, and they may respond by reducing the quantity of wheat they supply.Similarly, workers may notice a fall in their nominal wages before they notice that the prices of the goods they buy are also falling.
They may infer that the reward for working is temporarily low and respond by reducing the quantity of labor they supply.
In both cases, a lower price level causes misperceptions about relative prices, and these misperceptions induce suppliers to respond to the lower price level by decreasing the quantity of goods and services supplied.
Similarly misperceptions arise when the price level is above what was expected.
Suppliers of goods and services may notice the price of their output rising and infer, mistakenly, that their relative prices are rising.
They would conclude that it is a good time to produce. Until their misperceptions are corrected, they respond to the higher price level by increasing the quantity of goods and services supplied. This behavior results in a short-run aggregate-supply curve that slopes upward.
There are three alternative explanations for the upward slope of the short-run aggregate-supply curve:
- sticky wages,
- sticky prices, and
- misperceptions about relative prices.
Economists debate which of these theories is correct, and it is possible that each contains an element of truth. For our purpose, the similarities of the theories are more important than the differences.
All three theories suggest that output deviates in the short run from its natural level when the actual price level deviates from the price level that people had expected to prevail.
Notice that each of the theories of short-run aggregate supply emphasizes a problem that is likely to be temporary. Whether the upward slope of the aggregate-supply curve is attributable to sticky wages, sticky prices, or misperceptions, these conditions will not persist forever. Over time, nominal wages will become unstuck, prices will become unstuck, and misperceptions about relative prices will be corrected.
In the long run, it is reasonable to assume that wages and prices are flexible rather than sticky and that people are not confused about relative prices. Thus, while we have several good theories to explain why the short-run aggregate-supply curve slopes upward, they are all consistent with a long-run aggregate-supply curve that is vertical.