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TAX INCIDENCE: The ultimate payment of a tax. Many taxes are initially paid by one person, but passed along through production and consumption activities until it finally reaches someone else. An obvious example is the sales tax. While officially paid by the retail store (they write the check to the government), it's tacked on to the prices paid by consumers. Consumers, thus, bear the lion's share of most sales taxes. The incidence of other taxes is not quite so obvious. Some taxes are paid by producers early in production such as severance taxes on oil extraction without the knowledge of consumers, who end up paying through higher prices. As a general rule taxes are passed through the system until they reach someone (usually consumers) who can pass it no further.

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SLOPE, LONG-RUN AGGREGATE SUPPLY CURVE:

The long-run aggregate supply (LRAS) curve is a vertical line with an infinite slope, reflecting the independent relation between the price level and aggregate real production. A higher price level is associated with the same real production as a lower price level. This is the real production generated when resources are fully employed, that is, full-employment production.
Real production is unaffected by the price level because prices are flexible in the long run. Long-run price flexibility ensures that ALL markets (product, financial, and resource) are in equilibrium. There are no shortages or surpluses in any markets. Most important, resource markets, especially labor markets, are in equilibrium, with no surpluses or shortages and no cyclical unemployment or overemployment. The economy is operating AT full employment and real production is equal to full-employment real production.

Shifting the Curve
Shifting the Curve

Before examining the details of flexible prices, consider the typical long-run aggregate supply curve, labeled LRAS, presented in this graph. The vertical slope of this curve captures the independent relation between the price level and aggregate real production. What is most important about this independent relation is that long-run aggregate real production is ALWAYS full-employment real production AT EVERY PRICE LEVEL.

Click the [Lower Price Level] button to illustrate that the resulting real production does not change, but also remains at full-employment production. The lower price level corresponds to the same real production. Click the [Higher Price Level] button to illustrate that the resulting real production does not change, but remains at full-employment production. The higher price level corresponds to the same real production. Movements along this LRAS curve result because all prices are flexible.

Flexible Prices

By definition, the long run is a period in which ALL prices, particular resource prices, are flexible. This flexibility means resource markets eliminate shortages and surpluses and achieve equilibrium. In particular, unemployment causes a decline in wages until the surplus of labor is eliminated. Alternatively, labor market shortages that can lead to overemployment due to real wage imbalances, cause increases in wages until the shortages are eliminated. The end result is full employment and full-employment production.

Suppose, for example, that The Wacky Willy Company, which manufactures Wacky Willy Stuffed Amigos (those cute and cuddly armadillos, scorpions, and rattlesnakes), faces falling demand reflected by buyers willing and able to pay a lower price. With a lower price and less revenue, The Wacky Willy Company needs to cut production cost. In the short run, it is likely to do so by reducing production and resource employment rather than resource prices. In the long run, however, wages eventually fall, enabling Wacky Willy employment and production to return to their original full-employment levels.

The reason is that equilibrium in the labor market is determined by the real wage, the ratio of the nominal wage to the price level. Those on the demand-side of the labor market, including The Wacky Willy Company, hire employees based on the real wage paid. Those on the supply-side of the labor market, including employees of The Wacky Willy Company, offer their labor services in response to the real wage received. Equilibrium in the labor market, which is another way of saying full employment, is then generated by a specific real wage.

A Lower Price Level

A fall in the price level, which is what prompts The Wacky Willy Company to "temporarily" reduce production and employment, is not immediately matched by a decline in the nominal wage. This causes the real wage to increase. The higher real wage prompts employers and workers to change the quantities demanded and supplied. It induces workers on the supply-side of the labor market to increase the quantity of labor supplied, and perhaps more importantly, it prompts employers on the demand-side of the labor market to decrease the quantity of labor demanded.

In other words, while workers are willing to work more because the purchasing power of their wage payment is greater, this boost in the real wage means employers are inclined to hire fewer workers. The result is a labor market surplus, or cyclical unemployment. In the long run, this unemployment surplus is eliminated when the nominal wage declines. In fact, the nominal wage eventually declines by the same proportion as the decline in the price level. If the price level declines by 10 percent, the nominal wage also declines by 10 percent. This ensures that the real wage returns to its original, full-employment, equilibrium level.

Because the real wage is at the full-employment equilibrium level BEFORE the price level decline and the real wage is the same after the price level decline as before, the labor market is once again at the full-employment equilibrium level. The aggregate real production supplied AFTER the price level decline is exactly the same as BEFORE the price level decline. In other words, the decline in the price level has absolutely no affect on the aggregate real production.

A Higher Price Level

An increase in the price level works in exactly the same manner, albeit moving up rather than down. The higher price level, which prompts The Wacky Willy Company to "temporarily" increase production and employment, is not immediately matched by an equivalent increase in the nominal wage. As such, the real wage declines. This is what entices employers like The Wacky Willy Company to hire more workers. They do this through a combination of (1) hiring frictionally and structurally unemployed workers, (2) workers who misperceive actual changes in real wages, and (3) a general imbalance in the pace of change of different wages and prices.

The end result is a labor market shortage, or overemployment, that enables aggregate real production to exceed full-employment production. This persists only as long as the real wage is less than the full employment level. In the long run, this overemployment shortage is eliminated when the nominal wage increases. In fact, the nominal wage increases by the same proportion as the increase in the price level. If the price level increases by 10 percent, the nominal wage also increases by 10 percent. This ensures that the real wage returns to its original, full-employment, equilibrium level.

Because the real wage is at the full-employment equilibrium level BEFORE the price level increase and the real wage is the same after the price level increase as before, the labor market is once again at the full-employment equilibrium level. The aggregate real production supplied AFTER the price level increase is exactly the same as BEFORE the price level increase. In other words, the increase in the price level has absolutely no affect on the aggregate real production.

<= SLOPE, INVESTMENT LINESLOPE, NET EXPORTS LINE =>


Recommended Citation:

SLOPE, LONG-RUN AGGREGATE SUPPLY CURVE, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2018. [Accessed: April 25, 2018].


Check Out These Related Terms...

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


Or For A Little Background...

     | macroeconomics | gross domestic product | price level | macroeconomic markets | supply | supply curve | real gross domestic product | flexible prices |


And For Further Study...

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


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