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:
The short-run aggregate supply (AS) curve slopes upward because, in the short run, prices and wages are sticky—they do not adjust instantly to changes in economic conditions. As a result, firms respond to changes in the actual price level relative to the expected price level by altering their production levels. One major explanation is the sticky-wage theory, which helps explain this behavior.
Correct Completion of the Scenario:
If the actual price level turns out to be 110 (higher than expected), the firm’s output prices will rise, 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 increasing 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 rise above the natural level of output in the short run.
Explanation (300+ words):
In macroeconomics, the short-run aggregate supply (SRAS) curve shows the relationship between the price level and the quantity of goods and services that firms are willing to produce, holding input prices (like wages) fixed. The SRAS curve is upward-sloping because of rigidities in the economy, particularly in wage and price settings.
The sticky-wage theory is one of the key theories that explain this upward slope. According to this theory, wages are set based on expected future prices and are often determined through contracts that last several months or even years. These contracts are difficult to change in the short run. So when the actual price level rises above the expected level, the firm’s output prices increase but wage costs stay the same. This makes production more profitable, encouraging firms to increase output.
For example, suppose a firm agrees to pay workers \$15 per hour based on an expected price level of 100. If the actual price level rises to 110, the firm receives more revenue per unit sold, while paying the same wage costs. The profit margin increases, incentivizing the firm to produce more. If this happens economy-wide, aggregate output rises, explaining the upward slope of the SRAS curve.
This relationship is captured by the formula:
$$
\text{Quantity of Output Supplied} = \text{Natural Level of Output} + a \times (\text{Price Level Actual} – \text{Price Level Expected})
$$
Here, “a” is a positive constant reflecting how sensitive output is to unexpected price changes. This formula shows that when the actual price level is higher than expected, output rises above the natural level, and vice versa.