Question

True or False: If the price of oil suddenly increases by a large amount, AS will shift left, but the price level will not rise thanks to price inflexibility.

Short answer

False. Higher oil prices usually cause AS to shift left, raising the price level despite price inflexibility.

Step-by-step solution

Understanding AS and Price Level

Aggregate Supply (AS) refers to the total supply of goods and services that producers in an economy are willing and able to sell at a given overall price level. If the price of a key input like oil increases suddenly, it raises production costs, which often results in a leftward shift of the AS curve as producers cannot supply the same quantity at existing prices.

Explore Price Inflexibility

Price inflexibility, or sticky prices, refers to situations where prices do not adjust immediately to changes in economic conditions. However, while some prices may be slow to change, others like commodities tend to adjust quickly. Over time, sticky prices can adjust.

Analyze the Impact on Price Level

If the AS shifts left due to higher oil prices, the intersection of AS and Aggregate Demand (AD) occurs at a higher price level, unless offset by other factors like demand decreases. Despite price inflexibility, the overall price level tends to rise in response to a decrease in AS driven by cost-push inflation.

Evaluate the Truth of the Statement

The statement claims that despite a leftward AS shift, the price level remains constant due to price inflexibility. Given the analysis in the previous steps, the price level would likely rise even if some prices are sticky. Therefore, the statement is false.

Key concepts

Price Inflexibility

Price inflexibility, commonly known as sticky prices, refers to how some prices in the economy are resistant to change, even when the market conditions shift significantly. This often happens in the short term where certain goods and services do not immediately adjust to economic changes like a sudden increase in input costs. For example, even if oil prices soar, the price of bread or a haircut may not change instantly.
Price inflexibility can occur for several reasons:

• Menu costs: The physical or technological costs associated with changing prices. For businesses, updating prices can require time and resources.
• Contracts and agreements: Many wages, particularly, are set by contracts that cannot be easily altered on short notice.
• Market expectations: Businesses may expect that changes in input costs are temporary and that prices will stabilize soon, so they hold off from changing their prices.

Despite the tendency for some prices to remain sticky, other items, particularly commodities, are generally more flexible and adjust quickly to market changes.
Hence, even in a scenario where there's price inflexibility, significant events can lead to adjustments in the overall price level.

Production Costs

Production costs refer to the total expenses incurred by businesses in the creation of goods or services. These costs include expenses on raw materials, labor, equipment, and other input factors.
An increase in the price of critical inputs, such as oil, directly affects the production costs for many businesses. This is because oil is not only a primary energy source but also a key ingredient in various products.
When production costs rise, several impacts occur:

• Reduced Supply: Higher costs might lead businesses to reduce their output, as they cannot afford to produce the same quantity without incurring losses.
• Profit Margins: To maintain profit levels, firms might increase their prices or reduce operation costs elsewhere, which can disrupt business efficiencies.
• Aggregate Supply Shift: On a larger economic scale, increased production costs can cause the Aggregate Supply curve to shift left, indicating a reduction in total output at any given price level.

Understanding how production costs function is crucial as they play a significant role in economic phenomena like cost-push inflation.

Cost-Push Inflation

Cost-push inflation occurs when the cost of production increases, leading to a decrease in the aggregate supply of goods and services, which in turn, raises the overall price level. Think of it as inflation driven by rising costs across the supply chain rather than increased demand.
Several factors can drive cost-push inflation:

• Input Cost Increases: Significant hikes in critical commodities like oil or metals can push production costs up, influencing companies to charge higher prices.
• Wage Growth: Higher labor costs, due to increased wages or benefits, can also contribute to this kind of inflation.
• Supply Chain Disruptions: Events that complicate the supply chain, like natural disasters or geopolitical tensions, can lead to shortages, thereby inflating prices.

When businesses face these amplified costs, they may transfer the burden onto consumers through price hikes. This results in an inflationary pressure without corresponding increases in demand.
Cost-push inflation can be challenging to manage because it often requires structural changes or external factors to stabilize critical input costs.