Question

The short nun aggregate supply curve was constructed assuming that as the price of outputs increases, the price of inputs stays the same. How would an increase in the prices of important inputs, like energy, affect aggregate supply?

Short answer

In summary, an increase in the prices of important inputs, like energy, negatively affects aggregate supply by raising production costs and shifting the short-run aggregate supply (SRAS) curve to the left. This leads to a contraction in the economy's output and may result in inflationary pressures as firms need to increase their prices to cover higher input costs.

Step-by-step solution

Constructing the short-run aggregate supply curve

The short-run aggregate supply (SRAS) curve represents the relationship between the real output of goods and services produced in the economy and the overall price level. It is upward sloping because when the price of outputs increases, firms have an incentive to produce more since they can earn higher revenues for the same level of costs. This is possible because the prices of inputs, or the costs of production, are assumed to be constant in the short run.

What happens when input prices increase

An increase in the prices of important inputs, like energy, will raise the overall cost of production for firms. This means that the production of goods and services becomes more expensive, and firms will need higher revenue to maintain the same profit margins. Consequently, firms will need to raise their output prices in accordance with the increase in input costs.

Effect on the aggregate supply curve

When the input prices increase, the cost of production becomes higher for every level of output in the economy. This means that firms are willing to produce the same level of output only at higher price levels. To depict this effect on the SRAS curve, we will observe a shift to the left in the SRAS curve. The distance of the shift will depend on the magnitude of the increase in input prices and the elasticity of the SRAS curve.

Summary

In conclusion, an increase in the prices of important inputs, like energy, affects the aggregate supply negatively by increasing the cost of production and shifting the short-run aggregate supply curve to the left. This results in a contraction of output in the economy and, depending on the magnitude of the rise in input prices, may lead to an inflationary situation as firms need to raise their output prices to cover higher input costs.

Key concepts

Input Price Increase

Understanding the effect of an input price increase on the economy requires grasping what input prices are. Inputs are the resources used in the production of goods and services, such as raw materials, labor, and energy. An increase in input prices can occur due to various reasons, including supply disruptions, increased demand, taxation changes, or inflation.

When businesses face higher costs for their inputs, they need to make financial adjustments to maintain profitability. One common response is to increase the prices of their final products. This reaction ensures that the costs are somewhat passed on to the consumers. However, it's important to note that several factors, such as competition, price elasticity of demand, and the structure of the market, play a crucial role in determining how much of the input cost increase can be transferred to consumers.

Production Costs

The term 'production costs' encompasses all expenses associated with the creation of a product or service. These include not only the cost of inputs like materials and energy but also wages for labor, depreciation of machinery, and costs associated with compliance to regulations and taxes.

The concept of production costs is central to understanding the behavior of firms and their decision-making process concerning supply. A firm's primary goal is to maximize profits, which is the difference between revenue from sales and production costs. Therefore, when production costs increase, assuming other factors remain constant, profits are squeezed. Firms will then look for ways to either reduce costs or increase prices to offset the higher expenses. In the context of aggregate supply, changes in production costs across the economy can affect the pricing and production decisions of multiple firms, influencing the overall economic output.

SRAS Curve Shift

The short-run aggregate supply (SRAS) curve is a visual representation that economists use to understand the relationship between the total production and the price level for goods and services in the economy over a short period. This curve is typically upward sloping to represent how firms are generally willing to supply more at higher prices.

But what happens to this curve when production costs increase? An increase in production costs, often caused by a rise in input prices, leads to a shift of the SRAS curve to the left. Essentially, at each price level, firms are now only willing or able to supply less than before, due to higher costs diminishing their profits. The magnitude of this shift can vary based on how sensitive firms are to changes in input prices, known as the elasticity of supply. This shift can reduce the overall level of output and can also lead to higher prices for goods and services, contributing to inflation. It's crucial for students to recognize that while this leftward shift shows a decrease in the quantity supplied at every price level, it's not the same as moving along the curve which would happen if only the price level changed.