If price increases and wages are sticky, then
A firms produce less at higher prices.
B firms produce more at lower prices.
C firms produce more at higher prices.
D firms do not change output.
The correct answer and explanation is:
The correct answer is C: Firms produce more at higher prices.
When the price of goods or services increases, firms typically respond by producing more in the short run. This is because higher prices lead to higher potential revenues, which incentivize firms to expand their output in order to capitalize on the price increase. However, wages are said to be sticky, meaning they do not adjust quickly to changes in market conditions. Sticky wages can cause firms to experience higher profit margins when prices rise, as their wage costs remain constant while the revenue from sales increases. This gives firms an incentive to increase production.
In a competitive market, when prices rise, the marginal revenue from selling additional units increases. Firms respond by increasing their supply, as the additional revenue can help cover their fixed costs and lead to higher profits. The sticky nature of wages means that firms do not immediately face higher labor costs, so the incentive to produce more is stronger. This is especially true in the short run, where firms may have limited flexibility to change their production processes or labor costs quickly.
On the other hand, if wages were flexible, firms might experience higher costs as wages adjust to the higher price levels. This could reduce the incentive to increase production. However, with sticky wages, firms are more likely to respond to price increases by boosting output to take advantage of the higher revenue without a corresponding immediate increase in labor costs.
Therefore, the expected outcome in this situation is that firms produce more at higher prices because the price increase boosts profitability while labor costs remain fixed due to sticky wages.