Why Does the Short-Run Aggregate Supply Curve Slope Upward?
In macroeconomics, the distinction between the short run and the long run is commonly thought to be that, in the long run, all prices and wages are flexible whereas, in the short run, some prices and wages can't fully adjust to market conditions for various logistical reasons. This feature of the economy in the short run has a direct impact on the relationship between the overall level of prices in an economy and the amount of aggregate output in that economy.
In the context of the aggregate demand-aggregate supply model, this lack of perfect price and wage flexibility implies that the short-run aggregate supply curve slopes upward.
Why does price and wage "stickiness" cause producers to increase output as a result of general inflation? Economists have a number of theories.
One theory is that businesses are not good at distinguishing relative price changes from overall inflation. Think about it- if you saw that, for example, milk was getting more expensive, it would not be immediately clear whether this change was part of an overall price trend or whether something had changed specifically in the market for milk that led to the price change. (The fact that inflation statistics aren't available in real time doesn't exactly mitigate this problem either.) If a business owner thought that the increase in the price of what he was selling was due to an increase in the general price level in the economy, he or she would reasonably expect the wages paid to employees and the cost of inputs to soon rise as well, leaving the entrepreneur no better off than before.
In this case, there would be no reason to expand production. If, on the other hand, the business owner thought that his output was increasing disproportionately in price, he would see that as a profit opportunity and increase the amount of the good he was supplying in the marketplace. Therefore, if business owners are fooled into thinking that inflation increases their profitability, then we'll see a positive relationship between the price level and aggregate output.
In the context of the aggregate demand-aggregate supply model, this lack of perfect price and wage flexibility implies that the short-run aggregate supply curve slopes upward.
Why does price and wage "stickiness" cause producers to increase output as a result of general inflation? Economists have a number of theories.
One theory is that businesses are not good at distinguishing relative price changes from overall inflation. Think about it- if you saw that, for example, milk was getting more expensive, it would not be immediately clear whether this change was part of an overall price trend or whether something had changed specifically in the market for milk that led to the price change. (The fact that inflation statistics aren't available in real time doesn't exactly mitigate this problem either.) If a business owner thought that the increase in the price of what he was selling was due to an increase in the general price level in the economy, he or she would reasonably expect the wages paid to employees and the cost of inputs to soon rise as well, leaving the entrepreneur no better off than before.
In this case, there would be no reason to expand production. If, on the other hand, the business owner thought that his output was increasing disproportionately in price, he would see that as a profit opportunity and increase the amount of the good he was supplying in the marketplace. Therefore, if business owners are fooled into thinking that inflation increases their profitability, then we'll see a positive relationship between the price level and aggregate output.
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