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

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

• 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

• 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

• 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.

A Lower Price Level

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.

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

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.