Question

a) What is the difference between the short-run AS curve and the long-run AS curve? Define each and explain the underlying assumptions. What would cause each to shift either to the right or left? b) What does the concept “sticky wages” refer to? Explain its implications within the AD/AS model.

Answer 1

The short run AS can be defined as the amount of goods and services available in the market from the producers in the short run. The SRAS curve slopes upward and shows that businesses will provide higher level of output as prices increase. SRAS is primarily determined by price level and level of labor and capital. The long run AS is the amount of goods and services provided by all the businesses in an economy in the long run. The LRAS curve is a vertical line. This means that the level of output is now independent of the price level. The vertical LRAS signifies that the market has matured and the economy has reached its potential. Amount of capital stock, labor productivity, amount of labor force can are the primary determinants of LRAS.

The underlying assumptions for the SRAS are -

• The level of capital is fixed and hence businesses can't expand production.
• Resource prices and wages are sticky in the short run meaning they do not change in the short run i.e are inflexible.
• Menu costs are fixed i.e the price charged by firms as shown in catalogues are fixed. This is because it will be costly to do so for the firms.

The underlying assumptions for LRAS are -

• Prices and wages are fully flexible
• Amount of capital stock, labor productivity, amount of labor force are no more fixed in the long run.
• The economy is at its potential (or full employment level)
• In the long run there is no trade off between unemployment and inflation

The factors that cause SRAS to shift are -

• Subsidies for business will cause a right shift, Taxation will cause a left shift
• Increase in productivity will cause a right shift, decrease in productivity a left shift
• Decrease in input prices will cause a right shift, increase in input prices will cause a left shift
• An increase in expectation about future profits can shift SRAS to right and a expectation of future loss will shift SRAS left.

The factors that cause LRAS to shift are-

• Increase in quantity of factors of production like increased population and increased capital stock will shift LRAS to the right while a decrease in labor and capital stock (probably due to a disaster) will shift LRAS to the left.
• An increase in efficiency of labor due to better level of education and increase in capital productivity due to new and efficient technology will shift LRAS right. A decrease in labor and capital productivity (due to usage of obsolete technology) will shift LRAS left.
• Government policy that provide long run growth prospects will shift LRAS to right while a deterrent government policy will shift LRAS left.

"Sticky Wages" refer to the fact that wages are fixed due to labor contracts in the short run. Thus if there is a change in the economic conditions, the wages cannot adjust accordingly. Hence if due to a expansion in the economy (say a demand expansion), price levels increase. the nominal wage is sticky hence real wages fall. This allows firms to supply more output as prices arises. This is a prime reason why SRAS is upward slopping.

However in the long run. wages are flexible and free to adjust given the economic conditions. If prices rise, labor demand higher nominal wages. This allows for no output expansion as it is in the case of SRAS. Due to flexible wages, the LRAS is vertical and the potential output is produced with full employment at any given level of prices.