Question

Suppose that in Wageland all workers sign annual wage contracts each year on January \(1 .\) No matter what happens to prices of final goods and services during the year, all workers earn the wage specified in their annual contract. This year, prices of final goods and services fall unexpectedly after the contracts are signed. Answer the following questions using a diagram and assume that the economy starts at potential output. a. In the short run, how will the quantity of aggregate output supplied respond to the fall in prices? b. What will happen when firms and workers renegotiate their wages?

Short answer

Answer: In the short run, the quantity of aggregate output supplied decreases due to the fall in prices, as lower prices make labor more expensive for firms. In the long run, when firms and workers renegotiate their wages, the wages are likely to decrease, which will shift the SRAS curve to the right, resulting in an increase in the quantity of aggregate output supplied and a further decrease in the price level.

Step-by-step solution

Draw a basic Aggregate Demand and Aggregate Supply diagram

Start by drawing an Aggregate Demand and Aggregate Supply diagram with Real GDP (Y) on the horizontal axis and the Price Level (P) on the vertical axis. Include the Short-Run Aggregate Supply (SRAS) curve and the Long-Run Aggregate Supply (LRAS) curve, which represents potential output. Also, draw the initial Aggregate Demand (AD) curve.

Identify the initial equilibrium

Identify the initial equilibrium point (E0) where the AD curve intersects the SRAS curve. This point represents the initial price level (P0) and level of real GDP (Y0), which coincides with the potential output since the economy starts at potential output.

Analyze the short-run consequences of the unexpected fall in prices

Due to the unexpected fall in prices, the price level (P) drops. On the diagram, this is represented by a movement along the SRAS curve to a lower price level (P1) and a new equilibrium (E1). Since wages are fixed in annual contracts, the lower prices make labor relatively more expensive. As a result, firms will reduce production to save costs, leading to a decrease in aggregate output supplied in the short run.

Analyzing the renegotiation of wages

When firms and workers renegotiate wages, they will likely agree to a lower wage level due to the fall in the prices of final goods and services. Lower wages make labor cheaper for firms, encouraging them to hire more workers and increase production. This will shift the SRAS curve to the right, leading to a new short-run equilibrium (E2) with a lower price level (P2) and a higher level of real GDP (Y1). #a# In the short run, the quantity of aggregate output supplied will decrease in response to the fall in prices. #b# When firms and workers renegotiate their wages, the wages will likely decrease, which will shift the SRAS curve to the right, resulting in an increase in the quantity of aggregate output supplied and a further decrease in the price level.

Key concepts

Wage Contracts

Wage contracts play a crucial role in determining how the labor market functions. In Wageland, these contracts are signed annually on January 1st. Regardless of changes in the prices of goods and services throughout the year, the wages agreed upon in these contracts remain unchanged. This creates a situation where workers' earnings are fixed, providing stability for employees in terms of their expected income.
However, this rigidity can also pose challenges. If the prices of goods and services drop unexpectedly, as in this scenario, wages remain at the pre-determined level, potentially making labor costs high relative to the current economic conditions. This inflexibility in wages affects how firms respond to changes in the economy, especially in terms of aggregate supply. The fixed nature of wage contracts thus impacts short-run production decisions and can contribute to unemployment or reduced work hours if firms cut back on production to save costs.

Short-Run Equilibrium

Short-run equilibrium occurs when the quantity of aggregate output supplied equals the quantity demanded at a particular price level. In the short run, wages and some other prices are sticky—meaning they do not adjust immediately to changes in economic conditions. In Wageland, the economy starts at potential output, indicating an initial equilibrium where short-run aggregate supply (SRAS) intersects with aggregate demand (AD), at the initial price level P0.
When an unexpected fall in prices happens, the price level decreases to P1, causing a movement along the SRAS curve. Since wages are fixed, production costs are relatively high, prompting firms to reduce output to lower costs. This results in a new short-run equilibrium with decreased aggregate output supplied. Eventually, in the short run, output may fall below potential, creating an output gap where the economy isn't operating at its full capacity. This gap highlights the temporary nature of short-run equilibria and the adjustments required to move back toward potential output.

Price Level

In economics, the price level refers to the average of current prices across the entire spectrum of goods and services produced in the economy. It's an important measure as it impacts purchasing power and economic decision-making overall. A fall in the price level means that, on average, goods and services are cheaper, which can influence consumption, saving, and production decisions.
In Wageland, such a fall occurs unexpectedly after the wage contracts are signed. The decreased price level lowers firms' revenue while production costs remain constant due to fixed wages. This scenario makes labor relatively more costly compared to the revenue that firms receive for their output, leading them to supply less aggregate output in the short run.
Understanding the dynamics of the price level is essential for analyzing economic situations as it affects inflation rates, cost of living, and overall economic health. In the long run, as wages and prices adjust, the price level will eventually stabilize, aligning with the updated equilibrium conditions.

Aggregate Demand

Aggregate demand represents the total demand for goods and services within an economy at a given overall price level and in a specified period. It is composed of several factors, including consumption by households, investment by businesses, government spending, and net exports (exports minus imports).
In the context of the given scenario in Wageland, aggregate demand may not immediately adjust to the fall in the price level. Sticky wages can hinder quick adaptations in spending from consumers and firms, tempering changes in aggregate demand.
As the economy adjusts to the new price level post-fall, the initial intersection of AD and SRAS moves to a lower point of short-run equilibrium, reflecting decreased output. Upon renegotiation of wages, aggregate demand can eventually respond more fully, as lower wages potentially increase employment and output, encouraging increased consumption. This underscores the interconnectedness of aggregate demand with wages, price levels, and overall economic activity.