Why does aggregate supply slope upwards?

The aggregate supply curve does not slope upwards for the same reason that the supply curve slopes upwards for an individual firm. The aggregate price level applies to all firms within the economy, so a firm should not necessarily want to increase their supply in response to a price increase, as their input prices will also simultaneously increase. For example, when the price level increases from 100 to 200, the price for the firm might increase from $4 to $8, but the wage rate would also increase from $10 to $20. Since output and input prices increase proportionately, the level of production should not change. However, there are three reasons as to why it might slope upwards:

Sticky-wage theory

The sticky-wage hypothesis assumes that in the short-run nominal wages are fixed. For example, an employer and employee might agree to the wage rate $20 for the next year of employment.

Consider the real wage which is defined:

$$ realwage = \frac{nominal \text{ } wage}{price \text{ } level}$$

If the nominal wages are fixed in the short-run and the price level increases, this will cause the real wage to decrease. When the real wages decreases, this causes firms to want to produce more output as they are now receiving a higher price for their output, but are paying the same wage rate as before.

Sticky-price theory

Sticky price hypothesis assumes that in the short-run prices might remain fixed. The assumption is that when the price level increases there are some firms who do not increase their price.

The reason they do not increase their prices are:

  • Menu costs: It can be expensive to adjust prices
  • Long term contracts: Sometimes suppliers have agreed to a price with consumers in advance.
  • Desire not to make customers upset.

Suppose you are a firm who cannot adjust you price and the price level is below what you expected it might be when you set the prices. In this case, the firms will have a price higher than the expected price so will have less demand then expected, so will reduce the amount of output it prices. Therefore, the lower the price level the lower the output.

Misperceptions theory

The final theory is the misperceptions theory. It states that sometimes firms might confuse the increase in price level with an increase in demand for their product and will lead to them increasing their production, thus a positive relationship between the price level and output.

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