Chapter 42: Aggregate supply (2.2)

Transcription

1 Chapter 42: Aggregate supply (2.2) Key cncepts Aggregate supply (AS) and utput The upward slping AS curve shrt run aggregate supply () Shifts in The meaning f aggregate supply Describe the term aggregate supply Explain, using a diagram, why the shrt run aggregate supply curve ( curve) is upward slping Explain, using a diagram, hw the AS curve in the shrt run () can shift due t factrs including changes in resurce prices, changes in business taxes and subsidies and supply shcks - N real address f the K vs M side needed here Aggregate supply (AS) and utput The aggregate supply curve shws the ability and prpensity f firms t put gds n the market, r the relatinship between the price level and real utput. In the shrt run, the higher the price level, the mre gds firms will be able and willing t supply the shrt run aggregate supply curve will thus shw psitive crrelatin between the price level and real natinal incme. In the lng run, it is nt as simple, since there is great deal f cntrversy in the theretical divide between tw brad schls f thught. Definitin: Aggregate supply Aggregate supply is the planned utput f gds and services in an ecnmy during a perid f time at different price levels. There is psitive crrelatin between the price level and aggregate supply. (Nte that we assume that factr prices remain unchanged alng the AS curve.) The upward slping AS curve shrt run aggregate supply () Prductin takes place because suppliers anticipate revenue and prfit frm cming sales. Csts, n the ther hand, rise simultaneusly with suppliers increase in utput. Suppliers run a risk f nt receiving revenue enugh t match csts, since they cannt predict future prices. Therefre, shuld real prfits exceed expected prfits suppliers will have an incentive t increase utput, which strngly suggests an upward slping aggregate supply curve. Assuming that the prices f

2 all factrs f prductin (e.g. wage rates, raw material prices, price f capital, etc) remain cnstant, then suppliers will indeed increase utput when the price level rises. This is prtrayed in figure as the upward-slping prtin f the shrt run aggregate supply () curve. The aggregate supply f an ecnmy in the shrt run is based n the ntin f fixed factr prices and availability e.g. the cnstraints are similar t thse used in Chapter 4, that is t say, that all else remains cnstant the ceteris paribus assumptin. Figure: Shrt run aggregate supply () Price level (GDP deflatr, 1995 = 100)) Warning! Factr prices d NOT change in mving alng the. Bttle A 85 B GDP real/t (billins 2005 EUROs) HL; What hlds true fr a single firm will in this particular case hld true fr the aggregate, namely that increased utput will result in higher marginal csts the sum f MC curves fr individual firms will give us the curve fr the ecnmy as a whle. This helps explain the relatively high elasticity f aggregate supply in the shrt run. 90 C 95 Crk D E Physical limit Higher market prices will induce suppliers t increase utput. The AS curve is drawn under the assumptin that prices f factr inputs d nt change in the shrt run, s a higher price level means larger prfit margins fr firms. Thus the price level and utput are psitively crrelated. The upward slpe f AS als shws hw firms experience diminishing returns (as existing fixed factrs are ever increasingly utilised) and increasing scarcity f variable factrs. Bth serve t create bttlenecks in prductin. (Shwn by the shadwed bttle in the figure.) When it becmes impssible t increase utput in the shrt run, the physical limit f the ecnmy s capacity is reached and real GDP is n lnger crrelated t the price level. An increase in the price level simply means a general rise in prices withut any increase in utput. (Shwn by the crked prtin f the curve.) Let s lk at the three sectins f the curve in figure in turn: Hrizntal sectin: The hrizntal prtin f the shrt run aggregate supply curve shws utput when the ecnmy is in severe recessin, r depressin. Output can increase withut an increase in price, i.e. shrt run aggregate supply is hrizntal and therefre uncrrelated t the price level. Firms can increase prductin regardless f the price level

3 since there is: High unemplyment and thus abundant labur and inability t bid up wages n cst pressure n firms due t increasing wages Excess capacity in firms, which enables them t increase utput withut incurring higher (marginal) csts Lw demand in the ecnmy which makes firms unwilling/unable t raise their prices Upward slping sectin: At an utput beynd 80 billin (pint A and beynd n the shrt run aggregate supply curve) firms will increase utput in accrdance with a rise in final prices (= market prices) but will start t encunter diminishing returns and supply cnstraints. Fixed factrs f prductin such as machines, assembly lines and factry space will nt increase during the shrt run; diminishing returns set in. Adding t this is the increased scarcity f factrs as utput increases in the shrt run, leading t bttlenecks supply cnstraints in prductin; increased scarcity f skilled labur, transprtatin, delivery and availability f raw materials will all serve t limit firms ability t put mre gds n the market. (Remember, factr prices d nt change, s increasing prductin csts are the result f vertime, increasing maintenance csts f machines, search csts fr ever scarcer raw materials etc.) As firms csts increase there must be an incentive f higher (final) prices fr firms t be willing and able t increase utput. Pints A thrugh E shw the psitive crrelatin between the price level and real GDP. (The bttle in the diagram is my incredibly childish way f shwing that the upward slpe is due t bttlenecks in supply and NOT higher factr prices.) Vertical sectin: The vertical prtin f the shrt run aggregate supply curve (beynd E) illustrates hw the ecnmy ultimately hits the utput capacity ceiling. This is the physical limit f firms shrt run utput capacity. Up t pint E the ecnmy is able t increase utput by paying wrkers vertime, hiring ever mre labur and pushing capital t the limit. At sme pint (here E in the diagram) wrkers will be reluctant t wrk vertime, additinal labur will be unavailable, and firms will be unwilling t drive machines int the grund withut majr verhauls (= repairs and maintenance). The inducement f higher final prices will nt increase utput in firms n matter what the prfit margins are, s the shrt run aggregate supply curve becmes vertical r cmpletely inelastic. (The crk is a silly illustratin shwing that n mre flw e.g. utput is pssible at any pint beynd E.) A final technical nte: I have drawn the shape f the shrt run aggregate supply curve () in figure partially t shw the histrical link t Keynesian thery (see Chapter 43) and partially t illustrate the issue f hw an ecnmy will shw increasing difficulties in increasing utput due t supply bttlenecks. In the cntinuatin, I will cnfine the range f the shrt run aggregate supply curve t the upward-slping sectin, e.g. pints A t E. It is within the span f the upward-slping sectin that all shrt run analysis will take place and the hrizntal and

4 vertical sectins add little in terms f analytical value. This is als in keeping with what has becme standard mainstream usage f shrt run aggregate supply curves. Shifts in The shrt run aggregate supply curve in the AS-AD mdel will shift when prductin csts fr firms change. Three specific shrt run influences can be identified: 1. Price f labur: An increase in wage rates will mean higher prductin csts fr firms and shift the shrt run aggregate supply curve t the left, frm 0 t 2 in figure belw. This will result in lwer utput, Y 2, and a higher price level, P 2. A decrease in the wage rate will naturally have the ppsite effect. 2. Price f inputs: Changes in ther factr markets, e.g. the markets fr raw material, capital and cmpnents will have effects n the cst picture f industrial firms. Fr example, a decrease in the price f steel will enable prducers f cars, huses and washing machines etc t increase utput at all price levels. This is shwn by a shift in shrt run aggregate supply frm 0 t 1, increasing utput t Y 1 and lwering the price level t P Taxatin and legislatin: There are a variety f taxes levied n prductin which increase csts fr firms. Labur taxes (a percentage n wages paid by emplyers which g t scial security cntributins, pensins and such) add t verall labur csts. Prfit taxes (r crprate taxes) deny firms mney that culd be used fr investment. Envirnmental taxes n emissins add t firms csts. Legislatin n minimum wage rates; vertime regulatin; wrk hurs etc als add t the ttal cst picture f firms. Increased taxes n labur etc and stricter regulatry legislatin will shift shrt run aggregate supply t the left, frm 0 t 2, while lwer taxes and lser legislatin will shift the shrt run aggregate supply curve t the right, frm 0 t 1. Figure: Increase and decrease in shrt run aggregate supply Price level P 2 P 0 P 1 will shift primarily due t changes in the price f factrs and legislatin n taxes and labur. AD 0 Y 2 Y 0 Y 1 GDP real /t In additin t factrs affecting the price and availability f factrs f prductin, there are factrs such as the efficiency f factrs and external shcks. Imprvements in technlgy, labur and prductin methds will increase aggregate supply while severe strms and/r natural disasters can decrease aggregate supply.

5 Summary and revisin (need a cl pic here.maybe a pic f smene ding pushups!) 1. Aggregate supply is the planned utput f gds and services in an ecnmy during a perid f time. The shrt run aggregate supply curve is shws psitive crrelatin between the price level and planned utput. 2. A key assumptin f the curve is that factr prices and factr availability are cnsidered cnstant. Any change in these variables will shift the curve. 3. Shifts in shrt run aggregate supply are primarily caused by the price, availability, efficiency and quantity f factrs f prductin. Shrt run aggregate supply shifts due t: a. changes in factr prices (wages, raw material, capital) b. changes in factr efficiency (new technlgy, prductin methds) c. taxatin (prfit taxes, labur taxes, envirnmental taxes) d. gvernment regulatins (vertime regulatin, subsidies) e. external shcks (natural disasters, weather)