The short-run aggregate supply (SRAS) curve graphically represents the direct relation between the price level and aggregate real production. A higher price level is related to more real production and a lower price level is related to less real production. That is, the business sector is inclined to offer more total goods and services for sale if the price level rises and less if the price level falls.
The key question is: Why? Why does the short-run aggregate supply curve have a positive slope? While the general reason is similar to that of market supply curves--the opportunity cost of production--three specific reasons are at work:
- Inflexible resource prices that often makes it easier to reduce aggregate real production and resource employment when the price level falls.
- The pool of natural unemployment, consisting of frictional and structural unemployment, that can be used temporarily to increase aggregate real production when the price level rises
- Imbalances in the purchasing power of resource prices that can temporarily entice resource owners to produce more or less aggregate real production than they would at full employment.
Before examining the details of these three reasons, consider the specifics of what they do. A typical short-run aggregate supply curve, labeled SRAS, is presented in this graph. The positive slope of this curve captures the direct relation between the price level and aggregate real production. What is most important about this direct relation is that short-run aggregate real production can be greater or less than full employment real production.
|The SRAS Curve|
Note that the green vertical line in this graph designates the full employment level of real production.
Movements along this short-run aggregate supply curve result because of inflexible resource prices, natural unemployment, and purchasing power imbalances. But first, consider the key role played by the opportunity cost of production.
- With a higher price level, the economy can supply real production that exceeds the full employment level. Click the [Higher Price Level] button to illustrate this point.
- With a lower price level, the economy can supply real production that is less than this full employment level. Click the [Lower Price Level] button to illustrate this point.
Opportunity Cost of ProductionWhile the specific mechanism of moving along the short-run aggregate supply curve is more complex, the basic source of the short-run aggregate supply curve's positive is very similar to that for the standard market supply curves--the opportunity cost of production. For market supply, increased production of a good is associated with a greater opportunity cost of production, and thus supply price. Decreased production is related to a lower opportunity cost of production and supply price. The underlying reason for this direct relation between supply price and quantity supplied for market supply can be found in the law of diminishing marginal returns.
The positive slope of the short-run aggregate supply curve and the direct relation between price level and aggregate real production is also generally attributable to the opportunity cost of production. That is, an increase in the aggregate real production by the business sector in the short run involves a greater overall opportunity cost of production and thus price level. A decrease in aggregate real production is related to lower opportunity cost and price level. In other words, larger quantities of aggregate real production carry a higher price level because the opportunity cost of production is also greater.
Inflexible Resource PricesBy definition, the short run is a period in which some prices, particular resource prices, are inflexible. This inflexibility prevents resource markets from eliminating shortages and surpluses and achieving equilibrium. In other words, workers' wages do not decline even when unemployment rises. Inflexible resource prices, especially wages, are most important when the price level and real production decline. Faced with falling economic activity, resource employment and real production tend to fall first, bearing the brunt of the reduction, while resource prices remain relatively unchanged.
Suppose, for example, that The Wacky Willy Company, which manufactures Wacky Willy Stuffed Amigos (those cute and cuddly armadillos and turtles) faces falling demand reflected by a lower price that buyers are willing to pay. With 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.
The net effect is that The Wacky Willy Company opts to lay off a few workers, cut back on the purchase of other resources, and reduce the overall production of Stuffed Amigos. But it will continue to pay its workers and other resources the same wages and resource prices. Because firms throughout the economy make essentially the same choices in the short run, the economy's declining price level corresponds to a reduction in aggregate real production and resource employment. Even though unemployment is increasing, wages and other resource prices change very little, in the short run.
- One reason is that The Wacky Willy Company has multi-year contracts with its workforce and other resources. They CANNOT reduce resource prices without renegotiating these contracts.
- Another reason is that Wacky Willy workers view their wages as an indication of intrinsic self-worth. Even if The Wacky Willy Company can pay workers less, many would opt for temporary unemployment instead as they search for other jobs at the same pay.
- A third reason is that the process involved in laying off a few workers is often easier than reducing the wages for every worker on the payroll. It is a costly procedure for The Wacky Willy Company to update its computer payroll system with different wages for every employee.
- A fourth reason is that The Wacky Willy Company might decide to use this downturn as a opportunity to "clean house," to rid itself of the least productive workers.
- A fifth reason is that The Wacky Willy Company is a price taker in the labor market. Because it is forced to pay the going market wage for workers, it cannot pay workers less even if it wants to.
Natural UnemploymentNatural unemployment consists of frictional and structural unemployment.
Both types of unemployment are a natural part of a healthy, efficient, and expanding economy. And unlike cyclical unemployment, neither can be eliminated totally.
- Frictional unemployment results because it takes time for employers and workers to find one another.
- Structural employment results because the skills needed by employers do not match the skills possessed by the workers.
However, both frictional and structural unemployment can be reduced temporarily. And when they are reduced, the economy's total employment and aggregate real production increase. This pool of natural employment provides a means of increasing real production beyond full employment when the price level rises. A higher price level, brought about by expanding economic activity, entices firms and resource owners to incur the extra cost needed to reduce natural unemployment and increase real production.
Once again, consider the operation of The Wacky Willy Company. When business is booming, like any firm, The Wacky Willy Company is prompted to expand production by increasing the quantities of resources used. In other words, they hire more workers and buy more of the other resources used. While they are not particularly concerned with the economy's full employment level of production, it affects their ability to acquire the resources needed to produce more Stuffed Amigos.
In principle, if the economy is at full employment, then the only way for The Wacky Willy Company to acquire more resources is to hire them away from other firms. While this might work for The Wacky Willy Company, ALL firms in the economy CANNOT do this. When The Wacky Willy Company hires workers away from another firm, say Mona Mallard Duct Tape, then Mona Mallard has fewer workers and is forced to reduce production. Mona Mallard might then seek to maintain or even increase its workforce by hiring workers away from OmniMotors, Inc., forcing OmniMotors to reduce production. With full employment, greater production by one firm generally comes at the expense of less production by another.
Natural unemployment, however, provides a pool of resources that temporarily allows firms to circumvent the restrictions imposed by full employment. The Wacky Willy Company's pursuit of extra resources might actually draw from the pool of frictional and structural unemployment. For example, The Wacky Willy Company's employee search efforts might involve extensive use of classified ads, which provides the information needed to reduce the search time that exists when frictionally unemployed workers are without jobs. Alternatively, The Wacky Willy Company might provide training for workers who lacked the skills needed for Stuffed Amigos production. Doing so removes some people from the ranks of the structurally unemployed.
The result of The Wacky Willy Company's attempts to increase production, along with that of other firms throughout the economy, is that aggregate real production does increase. But this increase comes from drawing upon the ranks of frictional and structural unemployment. The extra cost of searching out frictionally unemployed workers and/or training structurally unemployed workers necessitates a higher price level.
Real Resource PricesThe quantities of resources supplied to firms depends on the purchasing power of the resource prices received, that is real resource prices. For labor, the common term is real wages.
Any combination of changes in nominal resource prices or the price level that changes the purchasing power of resource prices entices resource owners to change quantities supplied.
- If workers receive a higher nominal wage and the price level does not change, then the real purchasing power of their wages is higher and they are inclined to increase the quantity of labor supplied.
- If the workers receive the same nominal wage, but the price level increases, then the real purchasing power of their wages is lower and they are inclined to decrease the quantity of labor supplied.
Aggregate real production can increase or decrease--can be more or less than full employment production--when real resource prices are out of balance, that is, not the levels needed for full employment. Real resource price imbalances can result either from misperceptions of actual prices or different rates of price adjustments. In particular, if resource owners think real resource prices are higher (or lower) than they actually are, then they are inclined to supply larger (or smaller) resource quantities than that for full employment. Alternatively, real resource prices actually might be higher (or lower), temporarily, than that for full employment because some prices adjust faster than other prices. In either case, the result is that real production is greater (or less) than full-employment production.
Consider once again The Wacky Willy Company. Faced with booming sales, it might be inclined to increase workers' wages to entice the greater productive effort needed to keep pace with sales. Workers see these higher nominal wages as an increase in real wages, and decide to work longer, harder, and generally increase the quantity of their labor supplied. However, they could be misperceiving their real wage if the price level has also increased. And it is likely to be increasing because other firms throughout the economy are also increasing production and prices in response to the booming economy. This is a temporary situation because resource owners eventually realize that the price level has increased.
Alternatively, workers' higher nominal wages can actually increase real wages because the prices of other goods have not yet increased. The economy is dynamic, complex, and diverse. All prices do not change simultaneously. All production does not expand at the same time. The Wacky Willy Company could be at the forefront of an economic boom. It might take a few months or even years before other firms expand and raise their prices. Until they do, Wacky Willy workers might be experiencing a true, albeit short term, increase in real wages that does in fact justify greater production.
This imbalance in real wages can also affect The Wacky Willy Company in the face of declining sales. Should The Wacky Willy Company reduce workers' nominal wages, workers see this as a reduction in real wages. Like higher wages, this could be an illusion, because workers do not realize that the price level is also lower, or it could be actual, because many prices that make up the price level have not yet fallen. In either case, they reduce the quantity of labor supplied and The Wacky Willy Company produces fewer Stuffed Amigos.
The result of imbalances in real resource prices is that aggregate real production can increase above full employment if the price level is higher and fall below full employment if the price level is less. But these production levels are temporary. Once resource owners realize the price level has changed or once other prices actually do change, then the quantities of resources supplied will adjust back to their full employment levels. And when this happens, real production returns to full-employment production.
SLOPE, SHORT-RUN AGGREGATE SUPPLY CURVE, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2018. [Accessed: September 22, 2018].