Aggregate Demand & Supply
Part II: Supply
Aggregate Supply

Aggregate Supply = total goods & services
supplied
 Aggregate Supply Curve
 relates
total goods & services supplied to general
price level, Y = f(P)
  disagreement over derivation
 disagreement over shape

Theorists distinguish between short run and
long run aggregate supply curves
Aggregate S  si

Just as the aggregate demand curve is not equal
to the sum of individual demand curves, so too
with supply
 Individual supply curves are based on ceteris
paribus assumption
 But with general rise in price level, all prices
rise, including input prices so ceteris paribus
can't hold
Aggregate Supply = Results

So, aggregate supply is not really derived, it is
presented as what happens on the whole, the net
result of all firms responses to average changes
in the price level
 Yet, reasoning about the shape of the aggregate
supply curve is carried on in terms of the way
firms might be expected to act in various
situations --based on microeconomic theory
about firm decision making
Firm Theory

Microeconomic theory of the firm, says firms:
 maximize
net revenue or profit
 rising input prices shift cost curves up and (ceteris
paribus) reduce supply
 falling input prices shift cost curves down and
(ceteris paribus) increase supply

Let's look at an example:
Perfectly Competitive Firm - I

Output prices are given, max  w/ MC = MR
MC
price
AC
p1
given
price=
MR
Q1
Output
Perfectly Competitive Firm - II

If costs fall, output will rise, with MC' = MR
MC
MC'
price
Note:
p1
no change
in given
price!
Q1
Q2
Output
Perfectly Competitive Firm - III

If Output prices rise, output rises
MC
price
AC
p2
p1
P=MR
Q1
Q2
Output
Contradiction

Note, reasoning about aggregate supply relates
general price changes to output decisions
 But:
 FALLING
input prices result in increased output
 RISING output prices result in increased output
Solution?

Consider response of firms to overall price level
 what
this means is by no means clear, not in micro
theory

Consider firms' short run capacity
 in

micro terms this is shape of cost curve
Consider lags between increases in overall price
level and inputs, especially wages(!)
 Clearly, the reasoning is only partially based on
microeconomic firm theory
Positive Slope?

In general, it is assumed that in the short run
firms will INCREASE output as the price level
rises but with increasing difficulty as they
approach their capacity (i.e., costs increase)
determined by fixed production assets
 Because we are dealing with aggregates,
capacity is related, as in Keynesian theory, to
"full employment" level of Y
Aggregate Supply Curve

So, aggregate supply is assumed to look like
this:
AS
P
Y
Changing slope?

At low levels of Y, AS is assumed to be
relatively flat
AS
P
 excess
capacity
rationale: easy to
increase output,
input prices lag,
esp. wages
Y
Changing slope?

At higher levels of Y, AS is assumed to be
relatively vertical
P
 less
excess
AS
capacity
rationale: harder
tooutput as
input prices ,
esp. wages
Y
Wage - Price Relation

A central issue here is the relationship between
changes in prices and changes in wages
 do
wage changes lag price changes?
 do wage changes keep up with price changes?


e.g., indexed wages?
if prices & wages adjust the same, then profit maximization
would result in no change in output, --AS would be vertical
 because ALL wages
are almost never indexed, some
will fall behind and rising prices will increase profits
and result in higher output, e.g., upward slope
Shifts in AS curve

Anything that changes price - output
decisions will shift curve
P
AS
Y
Cost Shocks

Changes in basic costs, e.g., wages or oil,
change costs for most firms
P
 wages
costs
AS
AS
 oil price
costs
AS
Y
Growth & Stagnation

Changes in available means of
production, eg., labor or capital shifts AS
P
 labor
capacity
AS
AS
 capital
capacity
AS
Y
Public Policies

Policies that increase or decrease costs
shift AS
P
 EPA
costs
AS
AS
 regulation
costs
AS
Y
--END--