LAW OF DIMINISHING MARGINAL RETURNS: A principle stating that as more and more of a variable input is combined with a fixed input in short-run production, the marginal product of the variable input eventually declines. This is THE economic principle underlying the analysis of short-run production for a firm. Among a host of other things, it offers an explanation for the upward-sloping market supply curve. How does the law of diminishing marginal returns help us understand supply? The law of supply and the upward-sloping supply curve indicate that a firm needs to receive higher prices to produce and sell larger quantities. Why do they need higher prices?
Visit the GLOSS*arama
AGGREGATE SUPPLY INCREASE, SHORT-RUN AGGREGATE MARKET:
A shock to the short-run aggregate market caused by an increase in aggregate supply, resulting in and illustrated by a rightward shift of the short-run aggregate supply curve. An increase in aggregate supply in the short-run aggregate market results in a decrease in the price level and an increase in real production. The level of real production resulting from the shock can be greater or less than full-employment real production. While a wide range of specific aggregate supply determinants can cause an increase in aggregate supply, the following rank among the more important:
- Growth of the population or an increase in the labor force participation rate, both of which increase the quantity of labor available for production.
- Investment in capital goods prompted by lower interest rates, lower capital good prices, or technological advances, which increases the quantity of capital available for production.
- The discovery of new mineral deposits or fossil fuels, both of which increase the quantity of land resources available for production.
- An increase in education which increases the quality of labor resources.
- An increase in technology which increases the quality of capital resources.
- A reduction in wages or energy prices, both of which reduce economy-wide production cost.
The short-run aggregate market presented in the graph to the right sets the stage for analyzing the effect of an increase in aggregate supply resulting from a change in any aggregate supply determinant. The vertical axis measures the price level (GDP price deflator) and the horizontal axis measures real production (real GDP). The negatively-sloped curve, labeled AD, is the aggregate demand curve and the positively-sloped curve, labeled SRAS, is the short-run aggregate supply curve. The current short-run equilibrium, found at the intersection of the AD and SRAS curves, is a price level of 10 and real production of $100 billion.
Short-Run Aggregate Market
Consider what happens to this short-run aggregate market with an increase in aggregate supply. Suppose, for example, that changing customs and attitudes leads to an increase in the female labor force participation rate. This increases the total quantity of labor available for production. The result of this is a rightward shift of the SRAS curve. Click the [SRAS Increase] button to illustrate.
The result of this rightward SRAS curve shift is that a new short-run equilibrium is achieved at a lower price level (9) and a larger amount of real production ($110 billion). This result is comparable to that for a standard market. An increase in market supply results in a lower equilibrium price and a larger equilibrium quantity. The key difference, of course, is that this "market" is the aggregate product market for the entire economy and not the market for a specific good.
A comparative static analysis of the original equilibrium and the new equilibrium is useful and important. However, it is also instructive to dissect the adjustment process.
- First, the SRAS curve shifts rightward due to the increase in the quantity of labor induced by the increase in the female labor force participation rate. This "extra" aggregate supply creates an imbalance in the aggregate market. At the existing price level (which has NOT yet changed), buyers are willing and able to buy only $100 billion worth of real production. Producers, however, are now willing and able to sell more, something like $120 billion worth of real production. This creates economy-wide product market surpluses.
- Second, motivated by a build-up of inventories created by economy-wide product market surpluses, producers decrease production. In the short run they do so by reducing the employment of resources, especially labor. While resource prices do NOT decline enough to maintain full employment, the reduction in real production does lead to a decline in production cost which causes product prices and the price level to fall.
- Third, with the falling price level buyers are induced to increase aggregate expenditures. The combination of producers decreasing real production and buyers increasing aggregate expenditures act to reduce the existing economy-wide product market surpluses. In fact, as long as economy-wide product market surpluses persist producers decrease production, which causes the price level to fall, which increases aggregate expenditures. Eventually the falling real production and rising aggregate expenditures meet at the new short-run equilibrium price level of 9 and real production of $110 billion.
AGGREGATE SUPPLY INCREASE, SHORT-RUN AGGREGATE MARKET, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2024. [Accessed: February 24, 2024].
Check Out These Related Terms...
| | | | | | | | |
Or For A Little Background...
| | | | | | | | | | | | | | | | |
And For Further Study...
| | | | | | | | | |
Back to the WEB*pedia
Today, you are likely to spend a great deal of time looking for the new strip mall out on the highway seeking to buy either throw pillows for your living room sofa or a hepa filter for your furnace. Be on the lookout for door-to-door salesmen.
Your Complete Scope
This isn't me! What am I?
Only 1% of the U.S. population paid income taxes when the income tax was established in 1914.
"In war, there is no second prize for the runner-up."
-- Omar Bradley, US Army general
Capital Cost Allowance
Tell us what you think about AmosWEB. Like what you see? Have suggestions for improvements? Let us know. Click the User Feedback link.