Why Is Short Run Aggregate Supply Upward Sloping

The short-run aggregate supply (SRAS) curve illustrates the relationship between the aggregate price level and the quantity of aggregate output supplied in an economy, assuming that some factors, like wages and other input costs, are kept constant in the short run. Its upward-sloping nature is a critical concept in macroeconomics, explaining how economies respond to changes in aggregate demand and forming the basis for understanding short-term economic fluctuations.

The Basics of Aggregate Supply

Aggregate supply represents the total quantity of goods and services that firms are willing to produce and sell at various price levels. It is usually divided into two main time horizons:

• Short-Run Aggregate Supply (SRAS): This refers to the relationship between price levels and the quantity of output supplied when nominal wages and other input costs are fixed.
• Long-Run Aggregate Supply (LRAS): This reflects the potential output of an economy when all factors of production are fully employed. It is typically represented as a vertical line at the level of potential GDP.

Understanding the difference between the SRAS and LRAS is essential to understanding macroeconomic dynamics. Here, we will focus on the factors that explain the upward slope of the SRAS curve.

Why the Short-Run Aggregate Supply Curve Slopes Upward

The upward slope of the SRAS curve indicates that as the aggregate price level increases, firms are willing to supply more goods and services. Several key theories explain this positive relationship:

1. Sticky Wage Theory

One of the most prominent explanations for the upward slope of the SRAS curve is the sticky wage theory. This theory posits that nominal wages (the actual dollar amount paid to workers) are slow to adjust to changes in the economy, particularly in the short run.

• Wage Contracts: Many firms and workers enter into wage contracts that fix nominal wages for a certain period, often a year or more. These contracts prevent wages from immediately responding to changes in the price level.
• Menu Costs: Adjusting wages can be costly for firms. Menu costs, which refer to the costs associated with changing prices (or wages), can deter firms from frequently adjusting wages.
• Worker Morale: Firms may be hesitant to cut wages, even during economic downturns, because they fear it will lower worker morale and productivity.

How Sticky Wages Affect Aggregate Supply:

When the aggregate price level increases unexpectedly, firms receive more revenue for their products. However, because wages are sticky, their labor costs do not immediately increase. This leads to higher profits, incentivizing firms to increase production. Consequently, the quantity of aggregate output supplied rises, resulting in an upward-sloping SRAS curve.

Conversely, if the aggregate price level decreases unexpectedly, firms receive less revenue, but their labor costs remain relatively constant due to sticky wages. This reduces profits, causing firms to decrease production, further illustrating the positive relationship between the price level and aggregate supply.

2. Sticky Price Theory

Similar to sticky wages, the sticky price theory suggests that prices of goods and services are also slow to adjust to changes in the economy. Several factors contribute to price stickiness:

• Menu Costs: Similar to wage adjustments, changing prices can be costly. Firms incur costs for reprinting menus, updating price lists, and informing customers of price changes.
• Contracts: Many firms enter into contracts with customers that fix prices for a certain period. This prevents them from immediately adjusting prices in response to changes in demand or costs.
• Coordination Failures: Even if firms want to adjust prices, they may be hesitant to do so if they are unsure whether other firms will follow suit. This can lead to coordination failures, where firms collectively fail to adjust prices in response to economic changes.

How Sticky Prices Affect Aggregate Supply:

If the aggregate price level increases unexpectedly, some firms may be slow to adjust their prices due to stickiness. These firms will experience an increase in demand for their products because their prices are relatively lower compared to the new, higher average price level. To meet this increased demand, they will increase production, contributing to a higher quantity of aggregate output supplied.

Conversely, if the aggregate price level decreases unexpectedly, firms with sticky prices may find that their prices are relatively higher than the new, lower average price level. This will lead to a decrease in demand for their products, causing them to reduce production.

3. Misperceptions Theory

The misperceptions theory suggests that changes in the aggregate price level can temporarily mislead suppliers about what is happening in individual markets.

• Information Lags: Suppliers may not have perfect information about the overall economy and may misinterpret changes in the aggregate price level as changes in the relative prices of their specific products.
• Relative vs. Aggregate Price Changes: Suppliers need to distinguish between changes in the relative price of their product (compared to other goods and services) and changes in the overall price level.

How Misperceptions Affect Aggregate Supply:

If the aggregate price level increases unexpectedly, a supplier may initially believe that the demand for their product has increased, leading to a higher relative price. In response, they may increase production to take advantage of this perceived increase in demand. However, if the price increase is economy-wide, the supplier will eventually realize that the relative price of their product has not actually changed. Nevertheless, the initial increase in production contributes to a higher quantity of aggregate output supplied in the short run.

Conversely, if the aggregate price level decreases unexpectedly, a supplier may initially believe that the demand for their product has decreased, leading to a lower relative price. In response, they may decrease production. If the price decrease is economy-wide, the supplier will eventually realize that the relative price of their product has not actually changed. Nonetheless, the initial decrease in production contributes to a lower quantity of aggregate output supplied.

4. Input Costs and Production Capacity

Another factor that contributes to the upward slope of the SRAS curve is the relationship between input costs and production capacity.

• Increasing Marginal Costs: As firms increase production in the short run, they may encounter increasing marginal costs. This means that the cost of producing each additional unit of output increases as production levels rise.
• Capacity Constraints: Firms may also face capacity constraints, meaning they can only produce a certain amount of output with their existing resources and technology.

How Input Costs and Production Capacity Affect Aggregate Supply:

To incentivize firms to increase production despite increasing marginal costs and capacity constraints, the aggregate price level must rise. Higher prices allow firms to cover their higher costs and still earn a profit, thus encouraging them to supply more goods and services.

Conversely, if the aggregate price level is low, firms may not be able to cover their costs, particularly those with higher marginal costs or lower production efficiency. This will lead them to reduce production, contributing to a lower quantity of aggregate output supplied.

Factors That Shift the SRAS Curve

While the slope of the SRAS curve is determined by the relationship between the price level and aggregate output supplied, the curve itself can shift in response to changes in other factors. These factors include:

• Changes in Input Costs: If the costs of inputs, such as labor, raw materials, or energy, increase, the SRAS curve will shift to the left, indicating a decrease in aggregate supply at any given price level. Conversely, if input costs decrease, the SRAS curve will shift to the right.
• Changes in Productivity: Improvements in technology, education, or management practices can increase productivity, allowing firms to produce more output with the same amount of inputs. This will shift the SRAS curve to the right.
• Changes in Government Regulations: Changes in government regulations, such as environmental regulations or labor laws, can affect the cost of production and shift the SRAS curve.
• Changes in Expectations: Expectations about future inflation or economic conditions can influence firms' decisions about production and pricing, affecting the SRAS curve.

Implications for Macroeconomic Policy

The upward slope of the SRAS curve has important implications for macroeconomic policy. It suggests that policymakers can influence the level of aggregate output and employment in the short run by manipulating aggregate demand.

• Fiscal Policy: By increasing government spending or cutting taxes, policymakers can increase aggregate demand, leading to higher output and employment. However, this may also lead to higher prices.
• Monetary Policy: By lowering interest rates or increasing the money supply, policymakers can stimulate investment and consumption, leading to higher aggregate demand. Again, this may also lead to higher prices.

However, it is important to note that these policies only have short-run effects. In the long run, the economy will return to its potential output level, and changes in aggregate demand will only affect the price level.

Real-World Examples

Several real-world examples illustrate the upward slope of the SRAS curve:

• Oil Price Shocks: When oil prices rise unexpectedly, firms face higher energy costs, leading to a leftward shift in the SRAS curve. This results in lower output and higher prices, a phenomenon known as stagflation.
• Wage Increases: If wages rise unexpectedly due to union negotiations or labor shortages, firms face higher labor costs, leading to a leftward shift in the SRAS curve.
• Technological Innovations: Technological innovations that increase productivity can shift the SRAS curve to the right, leading to higher output and lower prices.

Conclusion

The upward slope of the short-run aggregate supply (SRAS) curve is a fundamental concept in macroeconomics. It reflects the positive relationship between the aggregate price level and the quantity of aggregate output supplied in the short run, when some factors, like wages and prices, are sticky. Several theories, including the sticky wage theory, the sticky price theory, and the misperceptions theory, explain this upward slope. Understanding the SRAS curve is crucial for understanding short-term economic fluctuations and the effects of macroeconomic policies.