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OPEN MARKET OPERATIONS: The Federal Reserve System's buying and selling of government securities in an effort to alter bank reserves and subsequently the nation's money supply. These actions, under the direction of the Federal Open Market Committee, are the Fed's number one, most effective, most often used tool of monetary policy. If, for example, the Fed wants to increase the money supply (termed easy money) it buy's government securities. If the Fed chooses to reduce the money supply (called tight money) it sells some government securities.

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SHORT-RUN AGGREGATE SUPPLY:

The total (or aggregate) real production of final goods and services available in the domestic economy at a range of price levels, during a period of time in which some prices, especially wages, are rigid, inflexible, or otherwise in the process of adjusting. Short-run aggregate supply, commonly abbreviated SRAS, is one of two aggregate supply alternatives, distinguished by the degree of price flexibility. The other is long-run aggregate supply. Short-run aggregate supply is combined with aggregate demand in the short-run aggregate market analysis used to analyze business-cycle instability, unemployment, inflation, government stabilization policies, and related macroeconomic topics.
Short-run aggregate supply captures a positive or direct relation between the economy's price level, measured by the GDP price deflator, and real production, measured by real GDP. Higher price levels entice the business sector to supply greater levels of real production and lower prices levels induce smaller levels of real production. This positive relation between the price level and real production means that the macroeconomy can achieve short-run equilibrium at real production levels that are either greater than or less than full-employment production.

The positive short-run relation between the price level and real production that IS short-run aggregate supply occurs because prices and wages tend to be rigid, inflexible, or sticky. In other words, prices do not adjust instantaneously to achieve equilibrium when resource markets have shortages and surpluses. This short-run aggregate supply relation can be better understood with a look at equilibrium adjustment in the three basic macroeconomic markets (product, financial, and resource), what this means for full employment, and the role played by different price adjustments.

Three Markets

The short run is characterized by price rigidity. But all prices are not equally rigid. Some prices adjust quickly and others more slowly. Prices in financial markets, for example, tend to adjust relatively fast, usually in a matter of hours or days. Prices in product markets, however, tend to adjust more slowly, usually measured in months. Resource market prices, especially wages, tend to be the slowest of the three to adjust, often taking years to reach equilibrium levels.

In most short-run macroeconomic analysis, financial and product markets are presumed to achieve equilibrium before resource (especially labor) markets. In fact, the working definition of the short run in aggregate market analysis is a period in which the financial and product markets are in equilibrium but the resource (especially labor) markets are not. In other words the bulk of the concern with inflexible prices is directly focused on resource prices, especially wages.

This means the short-run aggregate supply relation between the price level and real production presumes that shortages and surpluses HAVE BEEN eliminated from financial and product markets through flexible prices. However (and this is a very big however), shortages and surpluses HAVE NOT BEEN eliminated from resource markets, particularly labor markets. This means that resource markets are NOT in equilibrium and that resources are NOT fully employed.

The Short-Run Aggregate Supply Curve

The Short-Run Curve
The Short-Run Curve
A typical short-run aggregate supply curve, labeled SRAS, is presented in this graph. Consider a few highlights.
  • First, note that the price level is measured on the vertical axis and real production is measured on the horizontal axis. The price level is usually measured by the GDP price deflator and real production is measured by real GDP.

  • Second, note that the short-run aggregate supply curve, labeled SRAS, has a positive slope. Aggregate real production that the business sector offers for sale is greater at higher price levels and less at lower price levels.

  • Third, the price level and aggregate real production are the only two variables allowed to change in the construction of this curve. Everything else that could affect short-run aggregate supply is assumed to remain constant. Analogous to market supply, these other variables are ceteris paribus factors that fall under the heading of aggregate supply determinants.

  • Fourth, this short-run aggregate supply curve captures the relation between the price level and the flow of real production over a given time period, usually one year. However, depending on the particular aggregate market analysis, the time period could be shorter (one month or one quarter) or longer (year or more). Of course, if the time period is too long, then a short-run aggregate supply curve is not likely to be relevant.

Full Employment

The benchmark for the analysis of short-run aggregate supply is full employment production. In the long run, when all prices and wages are flexible, all markets (especially resource markets) are in equilibrium, and the level of real production fully employs all available resources. However, with inflexible resource prices in the short run, resource markets are NOT in equilibrium. This means that real production can be either greater or less than the level that would fully employ all resources.
  • Surplus and Unemployment: In particular, and perhaps most importantly, unemployment exists if resource markets have surpluses. If the quantities of resources supplied exceeds the quantities demanded, AT EXISTING PRICES, then surpluses exist. That is, some of the resources willing and able to engage in productive activities are NOT engaged in productive activities. They are unemployed. Of course, surpluses are eliminated when prices fall, but until they do, unemployment persists.

    With fewer resources engaged in productive activities, real production is less than the level generated at full employment. In other words, the level of real production can be LESS than full-employment production in the short run.

  • Shortage and Overemployment: Rigid prices can also create resource market shortages, in which the quantities of resources demanded exceeds the quantities supplied, AT EXISTING PRICES. This frequently creates a situation in which resources are actually "over employed." That is, resources are more heavily engaged in productive activities than they really want to be; or that they would be at full employment. Of course, shortages are eliminated when prices rise, but until they do, this overemployment persists.

    With resources more heavily engaged in productive activities, real production is more than the level generated at full employment. In other words, the level of real production actually can be GREATER than full-employment production in the short run.

Differing Price Adjustments

The reason that short run aggregate production can be more or less than full-employment production rests with the differing pace of price adjustments. In particular, changes in the price level are not met by equal changes in resource prices, especially wages.
  • A lower price level leads to a reduction in real production, below the full employment level, because wages and other resource prices do not fall at the same pace as the economy's overall price level.

  • A higher price level leads to an increase in real production, even above the full employment level, because wages and other resource prices do not rise at the same pace as the price level.
Consider how aggregate production and the employment of resources are affected by changes in the economy's price level.

A Lower Price Level

First, consider a reduction in the price level. Individual firms react to lower prices according to the basic microeconomic principles of short-run production, including the law of supply and law of diminishing marginal returns. Each firm reduces production by employing fewer resources. In so doing their per unit cost falls to match price reductions. When aggregated for the macroeconomy, total production declines and so too does the employment of resources.

While it IS possible that producers might seek to reduce their operating cost by reducing wages and other resource prices, it is usually easier to reduce quantities rather than resource prices. Reasons for this include:

  • One, many firms are price takers in resource markets with little or no ability to change resource prices. Should they try to pay resources less than the going market price, they might end up with NO resources. Firms, however, DO have control over the quantities of resources employed and output produced.

  • Two, workers and other resource suppliers are reluctant to accept lower wages and prices. In particular, the basic economic proposition that people prefer more to less makes workers reluctant to accept lower wages, especially when they provide the same productive effort. Moreover, workers often see wages as a measure of intrinsic self-worth. Any reduction is then viewed as something of a personal insult.

  • Three, workers and other resource suppliers might have long-term contractual arrangements with producers. Some firms employ unionized labor with wages contractually set by collective bargaining agreements. Other resources are also frequently supplied to producers under long-term contracts. In this case, it is just easier to temporarily lay off workers or reduce resource employment than to renegotiate contracts.

  • Four, producers might actually see this situation as an opportunity to "clean house," to rid their businesses of less productive resources. Firms find this a good time to lay off a few "deadbeat" workers. Not only does this reduce cost, it leaves a workforce that is, on average, more productive.

  • Five, wages and other resource prices are subject to a fair amount of inertia. They are what they are until something changes them. Because it is costly to actually change prices, to process the paperwork, firms need a reason to pay workers more or less. It is simply easier to maintain the same price.
Should prices remain low for an extended period, then producers are likely to re-evaluate their decisions, opting to reduce resource prices. Moreover, the macroeconomic forces at work in the long run tend to drive prices down in markets with price-taking producers. But, for a short period, temporarily reducing production and resource employment tends to work best.

The key consequences of a price level reduction are, of course, a decline in aggregate production and resource employment. Most importantly, if the economy was AT full employment, then it ends up with unemployment and less than full-employment production.

A Higher Price Level

Now, consider what happens with a price level increase. Individual firms react to higher prices, once again, according to the basic microeconomic principles of short-run production, including the law of supply and law of diminishing marginal returns. Each firm increases production by employing more resources and in so doing their per unit cost rises to match price increases. When aggregated for the macroeconomy, total production increases and so too does the employment of resources.

What holds for individual firms, however, must be re-evaluated for the macroeconomy. While one firm can increase production by acquiring resources from other firms, such may not be possible for the macroeconomy. In particular, if the macroeconomy is at full employment and resources are fully employed, then there are NO other production activities from which to acquire resources. However, it is possible to increase production in the short run. Reasons for this include:

  • One, workers and other resource suppliers might be temporarily fooled into thinking the purchasing power of their wages and prices has increased. This occurs because workers have close, personal knowledge of their wages when they cash their paychecks, but they are likely to have less information about the price level. Because they THINK their real wages and prices are greater they increase the quantities of their resources supplied. In other words, people work harder when they get paid more. And when they work harder, firms produce more.

  • Two, the purchasing power of the wages and resource prices received by workers and other resource suppliers might actually increase temporarily. This results because wages and prices do not all increase at the same pace. For example, wages might increase NOW, while the price level increases LATER. Because resource suppliers are actually receiving greater real wages and prices NOW, they increase the quantities of their resources supplied. Once again, people work harder when they get paid more. And when they work harder, firms produce more.

  • Three, even at full employment some resources, especially labor, remain frictionally and structurally unemployed. These resources represent a "pool" that can be enticed into production activities... under the right conditions. For frictionally unemployed resources, it means generating the information needed to match up available resources with available production activities. For structurally unemployed resources, it means retraining workers or otherwise reconfiguring the resources to match what the production activities need. Doing so, however, incurs a cost.
In these cases, workers and other resource suppliers can actually go beyond full employment, and produce more than full-employment production. But this is only a temporary, short-run situation. Eventually resource suppliers realize that real wages and resource prices have NOT increased, or if they have increased, all prices eventually adjust to the same level. Eventually efforts to use frictionally and structurally unemployed resources stop.

<= SHORT-RUN AGGREGATE MARKETSHORT-RUN AGGREGATE SUPPLY AND MARKET SUPPLY =>


Recommended Citation:

SHORT-RUN AGGREGATE SUPPLY, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2014. [Accessed: September 20, 2014].


Check Out These Related Terms...

     | aggregate supply | long-run aggregate supply | short-run aggregate supply curve | aggregate supply determinants | aggregate demand | aggregate market analysis | aggregate market | short-run, macroeconomics | long-run, macroeconomics |


Or For A Little Background...

     | gross domestic product | price level | GDP price deflator | real gross domestic product | full employment | unemployment | frictional unemployment | structural unemployment | overemployment | macroeconomic markets | resource markets |


And For Further Study...

     | change in aggregate supply | change in real production | aggregate supply shifts | slope, short-run aggregate supply curve | slope, long-run aggregate supply curve | business cycles | circular flow | Keynesian economics | monetary economics | short-run aggregate supply and market supply |


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