Question

1. Explain why the Aggregate Supply curve is upward sloping?

Answer 1

Answer :

Aggregate supply curve is upward sloping in short run. That means a decrease in the overall price level results in a lower quantity of goods and services supplied and vice versa.

There are three theories that try to explain why suppliers behave differently in the short run than they do in the long run: (1) the sticky wage theory, (2) the sticky price theory, and (3) the misperceptions theory. We will look at each of them in more detail below.

1. The Sticky Wage Theory

According to the sticky wage theory, the upward slope of the aggregate supply curve in the short-run is due to the fact that nominal wages are slow to adjust to changes in the overall price level (i.e., they are sticky). That means when the price level falls, most firms cannot adjust wages immediately, which leads to an increase in real production costs. As a consequence, the suppliers hire fewer workers and produce a smaller quantity of goods and services. According to this theory, the slow adjustment rate of wages is mainly caused by existing employment contracts and social norms that prevent frequent wage cuts.

For example, think of an imaginary firm that employs several workers. All of those employees have long-term contracts, and the firm has agreed to pay them a nominal wage based on the expected price level. Now, if the price level falls below the expected level, the firm’s real wages (i.e., nominal wages/price level) increase, which results in higher real costs. Meanwhile, revenue is likely to decrease due to the unexpectedly low price level. As a result, the firm hires fewer workers to cut costs and produces a smaller quantity output.

2. The Sticky Price Theory

The sticky price theory states that the short-run aggregate supply curve slopes upward because the prices of some goods and services are slow to adjust to changes in the overall price level. That means when the overall price level falls, some firms may find it hard to adjust the prices of their products immediately. This causes sales to drop, which in turn leads to a decrease in the quantity of goods and services supplied. According to the sticky price theory, the primary reason for sticky prices is what we call menu costs. Menu costs describe all costs incurred by firms in order to change their prices (e.g., printing new menus, distributing updated price lists, changing price tags on the shelves).

To illustrate this, imagine all firms announce their prices at the beginning of the year, based on the overall price level they expect. Then, throughout the year, the actual price level falls lower than expected. In reaction to this, some firms immediately lower their prices, while others decide to temporarily stick with their initial prices to avoid additional menu costs. In other words, they don’t want to (or can’t afford to) spend money on new brochures, price

lists, menus, etc. As a result, their prices are now too high, and sales decline. This, in turn, causes them to temporarily reduce production and hire fewer workers.

3. The Misperceptions Theory

According to the misperceptions theory, the short-run aggregate supply curve is upward sloping because changes in the overall price level can temporarily mislead suppliers about what is happening in their individual market. That means, when the price level falls, many firms will notice a fall in the price of the goods and services they sell and reduce production because they believe their business has become less profitable. However, if the overall price level falls, the prices of other products (including raw materials used for production) decrease as well. That means the relative price of the firms’ products doesn’t necessarily decline, and there is no actual reason to reduce the output.

To give an example, think of a firm that sells mobile phones. If the overall price level falls, the managers of this firm may notice a fall in the prices of mobile phones. Based on this observation, they may mistakenly believe that their business has become less profitable (i.e., their relative prices have fallen) and temporarily cut back on production and employment. Meanwhile, however, the prices of input materials have declined as well, so the relative price of mobile phones hasn’t changed, and their fear was unfounded.