What it’s: Short-run aggregate supply refers to aggregate output when some costs are variable. If we plot the curve, it has a positive slope, where aggregate output increases as the price level increases and vice versa.
The positive slope is due to several costs, such as wages, being inflexible. They tend to be rigid and do not fully adapt to changes in the price level. Thus, changes in the price level impact profit margins and ultimately affect business decisions related to increasing or decreasing production.
For example, wages and some other input costs remain constant when the price level rises. Thus, the profit margin is higher. This situation encourages businesses to increase output to earn more profits.
How do rigid wages affect short-run aggregate supply?
The wage rigidity theory (or sticky wage theory) explains why the short-run aggregate supply curve slows upward. If wages are sticky, profit margins rise when the price level rises. This situation incentivizes firms to increase output to achieve more profit. Conversely, profits fall if the price level falls because wages are unchanged, forcing them to cut production.
Wages are inflexible and change proportionately as the price level rises due to, among other things, employment contracts. In the short run, companies do not immediately revise their workers’ contracts by increasing wages to match the rising price level. Likewise, when the price level falls, wages will not necessarily fall. As a result, employment contracts make wages rigid.
In addition to employment contracts, wage rigidity is also caused by:
- Minimum wage
- Labor market regulations
- Union’s bargaining power
What is the difference between short-run and long-run aggregate supply?
Aggregate supply behaves differently in the short run and long run. Some inputs are sticky in the short run. But, conversely, all inputs are variables in the long run. This assumption has implications for the curve and the factors affecting aggregate supply.
The aggregate supply curve in the short run and long run
Because wages and some input prices are constant, an increase in the price level increases the firm’s profit margin. This situation encourages them to increase output to reap higher profits.
Conversely, wage rigidity prevents firms from reducing costs when the price level falls. As a result, profit margins decrease. As a result, they then cut output.
Long story short, aggregate supply is positively related to the price level in the short run. An increase in the price level increases aggregate supply and vice versa. Suppose we plot it on a graph, where the X-axis represents aggregate output, and the Y-axis represents the price level. In that case, the short-run aggregate supply curve (SRAS) has an upward slope.
In contrast, economists define the long run as the period in which all inputs are variable. Thus, input costs will rise and fall in proportion to changes in the price level. For example, if the price level rise, they rise proportionally. And conversely, if the price level falls, they will also fall.
Because input costs adjust proportionately, the profit margin does not change. Thus, firms have no incentive to increase production or decrease production. In other words, changes in the price level do not affect aggregate output in the long run.
The long-run aggregate supply curve forms a vertical line if we graph it.
Factors affecting aggregate supply in the short and long run
Changes in the price level only affect short-run aggregate supply but not long-run aggregate supply. And the change causes aggregate output to move along the short-run aggregate supply curve.
In addition, changes in short-run aggregate supply are also affected by changes in input costs, such as changes in raw material prices, nominal wages, taxes, subsidies, and exchange rates. In contrast, these factors do not affect long-run aggregate supply.
Long-run aggregate supply changes if there is a change in the quantity and quality of the factors of production. For example, more advanced technology allows the economy to produce more goods and services. Likewise, increased physical capital increases productive capacity, making it possible to produce more output. These factors also affect aggregate supply in the short run.
What causes the short-run aggregate supply curve to shift?
In the curve above, economists use the price level to explain changes in aggregate output (real GDP). Then, they plot aggregate output for each price level to produce a short-run aggregate supply curve. Thus, a change in the price level will cause aggregate output to change, but it simply moves along the curve. It doesn’t shift the curve right or left.
The short-run aggregate supply curve shifts to the right or left when the non-price determinant changes. These factors may affect production costs. Or they affect the productive capacity of the economy.
Several factors cause the short-run aggregate supply curve to shift:
- Input price
- Future price expectations
- Business tax
- Production subsidies
- Exchange rate
- Labor supply and quality
- Capital stock and its quality
What causes the short-run aggregate supply curve to shift to the right?
Input prices fall. Changes in the prices of inputs such as wages, raw materials, and energy impact profit margins. If their prices fall, production costs fall, increasing profit margins. This encourages businesses to increase output.
Future prices rise. Future price expectations impact businesses’ decisions to change their production. It affects their optimism (pessimism) about future profits.
If companies expect prices to rise in the future relative to the general price level, they see higher profit margins. So to get more profit, they will build up inventory by increasing output. And if more firms become optimistic, it will raise aggregate output.
Business taxes are down. Lower taxes reduce production costs per unit. As a result, profits increase, prompting businesses to increase output.
Production subsidies. Subsidies work in reverse compared to taxes. An increase in subsidies helps firms reduce costs, encouraging them to increase output.
The exchange rate appreciates. The appreciation makes the imported goods’ prices – such as raw materials, capital goods, and energy – cheaper. As a result, production costs decrease. And companies enjoy higher profit margins and are encouraged to increase production.
The labor supply is increasing, and/or their quality is improving. Therefore, the economy can produce more output when more labor is available. Likewise, laborers are more productive and can produce more output using the same input as laborers become more qualified.
Capital is more available and of higher quality. For example, the economy produces more output when more machines are available. Likewise, technologically more sophisticated machines (quality) also allow the economy to produce more output with the same output.
More advanced technology. More advanced technology makes labor and capital more productive and increases aggregate output.
What causes the short-run aggregate supply curve to shift to the left?
Short-run aggregate supply falls when the above factors work in reverse. So, in short, the short-run aggregate supply curve shifts to the left because:
- Input price goes up
- Future prices fall
- Business tax increases
- Subsidies in trim
- Domestic currency depreciates
- Labor supply is reduced
- Lower quality workforce
- Capital stock decreases
- Capital quality is deteriorating
- Technology setback
What to read next
- Aggregate Supply: Types, Curves, and Determinants
- Long-Run Aggregate Supply: Its Curve And Influencing Factors
- Short-Run Aggregate Supply: Its Curve and Determinants
- Supply Shock: Examples, Causes, Effects
- Very Short-Run Aggregate Supply: Its Curve and a Brief Explanation