5 . Why the aggregate supply curve slopes upward in the short run In the short run, the quantity of output that firms supply can deviate from the natural level of output if the actual price level in the economy deviates from the expected price level. Several theories explain how this might happen. For example, the sticky-wage theory asserts that output prices adjust more quickly to changes in the price level than wages do, in part because of long-term wage contracts. Suppose a firm signs a contract agreeing to pay its workers $15 per hour for the next year, based on an expected price level of 100. If the actual price level turns out to be 110, the firm’s output prices will and the wages the firm pays its workers will remain fixed at the contracted level. The firm will respond to the unexpected increase in the price level by the quantity of output it supplies. If many firms face similarly rigid wage contracts, the unexpected increase in the price level causes the quantity of output supplied to the natural level of output in the short run. Suppose the economy’s short-run aggregate supply (AS) curve is given by the following equation: Quantity of Output Supplied = Natural Level of Output + a x ( Price Level Actual – Price Level Expected
The correct answer and explanation is:
Correct Answer:
- The firm’s output prices will increase.
- The wages the firm pays its workers will remain fixed.
- The firm will respond to the unexpected increase in the price level by increasing the quantity of output it supplies.
- The unexpected increase in the price level causes the quantity of output supplied to rise above the natural level of output in the short run.
Explanation:
The aggregate supply curve slopes upward in the short run due to three primary theories: the sticky-wage theory, the sticky-price theory, and the misperceptions theory. The sticky-wage theory suggests that wages are slow to adjust due to long-term contracts and social norms. When the actual price level is higher than expected, firms can sell their goods at higher prices, but their wages remain fixed due to prior agreements. This makes labor relatively cheaper, encouraging firms to hire more workers and increase production.
For instance, if a firm signs a contract to pay workers $15 per hour under an expected price level of 100, but the actual price level rises to 110, the firm’s output prices will rise accordingly, while wages remain unchanged. Since the firm can now sell its goods at a higher price without a proportional increase in labor costs, it becomes more profitable to increase production.
Similarly, if most firms face rigid wage contracts, a higher-than-expected price level will lead to an economy-wide increase in output in the short run. This results in a positive relationship between the price level and the quantity of output supplied, explaining why the short-run aggregate supply (AS) curve slopes upward.
The given equation: Quantity of Output Supplied=Natural Level of Output+a×(Price Level Actual−Price Level Expected)\text{Quantity of Output Supplied} = \text{Natural Level of Output} + a \times (\text{Price Level Actual} – \text{Price Level Expected})
demonstrates this relationship mathematically. When the actual price level exceeds expectations, the term (Price Level Actual−Price Level Expected)(\text{Price Level Actual} – \text{Price Level Expected}) is positive, leading to an increase in output beyond its natural level.
Now, I’ll generate an image illustrating the upward-sloping short-run aggregate supply curve.
Here is the economic graph illustrating the short-run aggregate supply (SRAS) curve, showing its upward slope and how an increase in the actual price level leads to higher output. Let me know if you need any modifications or further explanations!
