What’s it: Short-run aggregate supply refers to aggregate output when some costs are variable. However, wages and some other input costs are inflexible and do not fully adapt to the price level changes.
When the price level rises, wages and some other input costs remain constant. Therefore, firms can then increase profits by increasing output.
Employment contracts are a source of wage rigidity. Companies do not automatically revise their labor contracts by increasing wages to match the rising price level in the short run. Likewise, when the price level falls, wages will not immediately fall. Other factors contributing to wage rigidity are minimum wages, labor market regulations, and union strength.
How short-run aggregate supply differs from long-run aggregate supply
Short-run aggregate supply. In a graph where the X-axis represents aggregate output, and the Y-axis represents the price level, the short-run aggregate supply (SRAS) curve has an upward slope. It shows an increase in the price level encourages an increase in aggregate output, represented by real GDP.
Remember, in the short run, we are assuming constant wages and some input prices. Therefore, an increase in the price level increases the company’s profit margin. This situation encourages them to increase output to obtain higher profits.
Conversely, firms cannot adjust their wages and input prices down when the price level falls. As a result, the profit margin decreases. They then cut output.
Long-run aggregate supply. Here, we assume that wages and other input prices are variable. That means they will rise and fall following the trend of the price level. If the price level rises, they will increase proportionately. Likewise, if the price level falls, they will also fall proportionately.
What are the implications? Since input costs adjust proportionately, profit margins will not change. Thus, the company has no incentive to increase production or reduce production. As a result, if we plot the relationship between real GDP and the price level, the long-run aggregate supply curve will be vertical.
As a note, in the long run, we assume, factors of production such as capital, labor, and technology are fixed. Thus, the only way to shift the long-run aggregate supply curve is to increase the quantity and improve capital and labor quality. The critical factor for improving the quality of both is technology.
A shift in the short-run aggregate supply curve
In the curve above, you can see, the economist uses the level of prices and aggregate output (real GDP) to plot the short-run aggregate supply curve. Thus, a change in the price level causes output to change and move along the curve. It will not shift the curve right or left.
And, a curve shift to the right or left occurs when other determinants change. These factors may affect the production cost or affect the availability and quality of the capital or labor (long-run factors). Belo, factors shift the short-run aggregate supply curve:
- Input prices, such as wages, raw materials, energy, and other inputs.
- Expectations of future prices
- Business tax
- Production subsidy
- Domestic currency appreciation
- Labor supply and their quality
- Capital stock and their quality
- Technology
Assuming the price level are unchanged, the short-run aggregate supply curve shifts to the right when:
A lower input price. For example, lower wages, lower production costs, increase profits and encourage businesses to increase output.
Higher future price expectations. Business expectations show you the optimism (pessimism) of the company in generating future profits. Suppose businesses expect their product’s price to increase in the future, relative to the general price level. In that case, they see a higher profit margin. To get a better profit margin, the company will build up inventory by increasing output. As more firms become optimistic, it will increase aggregate output.
Decrease in business taxes. Lower taxes reduce unit production costs. Business profits increase and encourage them to increase output.
Increase in the production subsidy. Subsidies work in reverse with taxes. The increase in subsidies helps companies reduce costs. That will encourage them to increase output.
Domestic currency appreciation. Appreciation makes imported goods cheaper, including inputs such as raw materials, energy, and intermediate goods. As a result, production costs decrease. Companies enjoy higher profit margins and encourage them to increase production.
Increasing supply and improving the quality of labor. An economy can produce more output when a more generous supply of labor is available. Likewise, improving the quality of workers increases their productivity. Thus, they can produce more output using the same input.
Increase in stock and quality of capital. The economy can increase output when more machines become available. Likewise, machines with more sophisticated technology (quality) can also increase output through improved productivity.
Furthermore, if the factors work in reverse, it lowers aggregate output. Thus, we can conclude, the short-run aggregate supply curve shifts to the left because of:
- Increase in input prices
- Lower future price expectations
- Increased business taxes
- Cut production subsidies
- Domestic currency depreciation
- Decreasing supply of labor shrinks or is of quality
- Decreased supply of the capital stock or its quality (for example, due to technological regress)
