Question

Why does the short-run aggregate supply curve slope upward?

Short answer

The short-run aggregate supply curve slopes upwards due to the Sticky-Wage Theory, Sticky-Price Theory, and the Misperceptions Theory. The Sticky-Wage Theory proposes that when the overall price level increases, real wages decrease, encouraging businesses to increase output. The Sticky-Price Theory suggests that firms with flexible prices will raise their prices and output when the price level rises, whereas those with sticky prices will be slower to react, causing aggregate supply to increase. Lastly, the Misperceptions Theory infers that firms might mistake changes in the overall price level as relative changes in their prices, leading to an increase in production.

Step-by-step solution

Understand the Question and Gather Information

The exercise is asking why the short-run aggregate supply curve slopes upwards. The aggregate supply curve represents the total quantity of goods and services firms are willing and able to supply within an economy at different price levels, holding all else constant. In the short run, the aggregate supply curve slopes upward indicating a positive relationship between the price level and the quantity of goods and services supplied. This phenomenon is explained by several theories.

Discuss the Sticky-Wage Theory

Sticky-Wage Theory assumes that the wages of workers are 'sticky' or slow to respond to changes in supply and demand. This means that in the short run, real wages may be 'too high' leading to unemployment or 'too low' leading to labor shortages. When the overall price level increases, real wages decline, making labour cheaper. Businesses respond by increasing output, hence, the aggregate supply curve slopes upward.

Discuss the Sticky-Price Theory

According to the Sticky-Price Theory, prices of some goods and services also adjust sluggishly in response to changes in demand or supply. When the overall price level increases, firms with flexible prices will raise their prices and output, but firms with sticky prices are slower to respond. As a result, aggregate supply increases, which explains the upward slope.

Discuss the Misperceptions Theory

The Misperceptions Theory suggests that firms may temporarily confuse changes in the overall price level with changes that are specific to their firm or industry. If the overall price level rises more than expected, firms perceive this as a relative increase in their prices, leading them to increase production. This results in a higher level of aggregate supply, contributing to the upward slope of the curve.

Key concepts

Sticky-Wage Theory

The sticky-wage theory provides an explanation for why the short-run aggregate supply (SRAS) curve slopes upwards. Simply put, this theory suggests that workers' wages tend to be slow to adjust to changes in economic conditions. This stickiness in wages can happen because of several factors, such as long-term labor contracts, social and legal wage norms, or even worker expectations.

When there's an increase in the overall price level in the economy, real wages—or wages adjusted for inflation—tend to decrease. This decrease makes hiring labor cheaper for businesses, incentivizing them to increase production since they can do so at a lower relative cost. More production means an increase in the total quantity of goods and services being supplied in the economy, hence the upward slope of the SRAS curve.

Furthermore, if wages were perfectly flexible and could instantly adjust to changes in the market, workers would demand higher nominal wages to maintain their purchasing power during periods of inflation. As this rarely happens immediately, the short-run is characterized by a lag, allowing output to potentially increase as businesses take advantage of lower real wage costs.

Sticky-Price Theory

The sticky-price theory delves into the slow adjustment of prices for goods and services. Much like wages, not all prices in an economy adjust quickly to shifts in demand or supply. Reasons for this sluggish adjustment include menu costs (the cost of changing prices), long-term contracts with suppliers and customers, or a firm's desire to avoid alienating their customers with frequent price changes.

In this context, when the overall price level in the economy rises, not all firms will immediately adjust their prices. Some firms' prices remain "sticky" or unchanged due to the reasons mentioned earlier. Firms with flexible pricing may immediately increase their prices, but firms with sticky prices will continue to sell their products at the old, lower prices until they adjust. As inflation persists, these firms benefit from higher demand since their relatively lower prices attract customers, leading them to gradually increase output.

Thus, even as the overall price level increases, the aggregate supply increases too, since businesses are supplying more. This contributes to the upward slope of the SRAS curve, as firms with flexible pricing can adjust output quickly, while others catch up slowly over time.

Misperceptions Theory

The misperceptions theory offers another perspective on the upward-sloping nature of the SRAS curve. It has to do with how firms perceive and react to changes in the price level. According to this theory, firms might misconstrue changes in the overall price level as changes specific to their products or sector. This can result from imperfect information, where managers and business owners are not fully aware of whether a price change reflects broader economic shifts.

If the overall price level rises unpredictably, firms might misperceive this as an increased relative demand for their goods or services. Believing their prices have risen in relation to others, firms may respond by ramping up production, thinking they need to meet a now higher demand for what they are offering.

• This perceived increase benefits them temporarily until they learn about the true nature of the price change.
• This results in a temporary increase in output as firms adjust their perceptions and actions according to the new level of prices.

Consequently, these reactions by numerous firms across the economy contribute to the upward slope of the short-run aggregate supply curve. Over time, firms correct their misperceptions, but the collective reactions lend an initial upward 'kink' to the supply curve in the short run.