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introduction to Aggregate Supply Models

Aggregate Supply Explained

Rising prices are typically an indicator that businesses should expand production to meet a
higher level of aggregate demand. When demand increases amid constant supply, consumers
compete for the goods available and, therefore, pay higher prices. This dynamic induces firms to
increase output to sell more goods. The resulting supply increase causes prices to normalize and
output to remain elevated.

Changes in Aggregate Supply

A shift in aggregate supply can be attributed to many variables, including changes in the size and
quality of labor, technological innovations, an increase in wages, an increase in production costs,
changes in producer taxes, and subsidies and changes in inflation. Some of these factors lead to
positive changes in aggregate supply while others cause aggregate supply to decline. For
example, increased labor efficiency, perhaps through outsourcing or automation, raises supply
output by decreasing the labor cost per unit of supply. By contrast, wage increases place
downward pressure on aggregate supply by increasing production costs.

Aggregate Supply Over the Short and Long Run

In the short run, aggregate supply responds to higher demand (and prices) by increasing the
use of current inputs in the production process. In the short run, the level of capital is fixed, and a
company cannot, for example, erect a new factory or introduce a new technology to increase
production efficiency. Instead, the company ramps up supply by getting more out of its existing
factors of production, such as assigning workers more hours or increasing the use of existing
technology.

In the long run, however, aggregate supply is not affected by the price level and is driven only by
improvements in productivity and efficiency. Such improvements include increases in the level
of skill and education among workers, technological advancements, and increases in capital.
Certain economic viewpoints, such as the Keynesian theory, assert that long-run aggregate
supply is still price elastic up to a certain point. Once this point is reached, supply becomes
insensitive to changes in price.

Top 4 Models of Aggregate Supply of Wages (With Diagram)

1. Sticky-Wage Model 4. The Sticky-Price Model.

2. The Worker Misconception Model

1.1 Sticky-Wage Model

The proximate reason for the upward slope of the AS curve is slow (sluggish) adjustment of
nominal wages.

In most organist industries nominal wages are set for a number of years on the basis of long-term
contracts. So wages do not move up or down whether the economy speeds up or slows down.

The range of wage movements is also narrow in those industries not covered by formal contacts
due to implicit agreements between employees and employers. Wages may also depend on
conventions, or social norms as the classicists like David Ricardo had postulated, as also on the
concept of justice (fairness) that evolves over time. For all these reasons nominal wages are
taken as sticky in the short run.

The following three things happen to aggregate output when the price level rises:

1. When the nominal wage is stuck, a rise in 2. This induces firms to hire more labour.
the price level lowers the real wage,
reducing the real cost of labour. 3. As a result output increases.

Thus, there is a positive relationship between the price level and the amount of output produced.
This means that the AS curve is upward sloping even when the nominal wage cannot adjust.

Here we assume that workers and firms voluntarily agree to accept a particular nominal wage on
the basis of collective bargaining. They do not know at this stage what the price level will be
when the wage agreement becomes effective.

Both the parties have in mind a target real wage, which is likely to be higher than its market
clearing level for two reasons:

(i) the bargaining power of trade unions, and (ii) efficiency-wage considerations.
The employees and employers set the nominal wage (W) on the basis of the target real wage (w)
and the expected price level (Pe):

W = w.Pe … (2)

After setting the nominal wage and before hiring labour, firms come to know exactly what the
actual price level (P) is. So the real wage turns out to be:

W/P = w.Pe/P … (3)

The real wage is nominal wage times the ratio of the expected price level to actual price level.

This implies that the real wage deviates from its target if the actual price level deviates from its
expected level:

(i) when P > Pe, W/P < w (ii) (ii) when P < Pe, W/P > w

Finally we assume that the level of employment is determined by the firms’ demand for labour at
the predetermined wage, and not by a collective bargaining process. The demand function for
labour is expressed as

Ld = f(W/P) where f'(W/P) < 0 …(4)

which means that the lower the real wage, the higher is the demand for labour by firms. The level
of output is determined by the production function

Y = F(L)

The more labour is hired, the more output proud .

Watch the Sequence and Note the Causation:

1. An increase in P in part (c) reduces (W/P) 3. As a result Y increases in part (b) and part
in part (a). (c) from Y1, to Y2.

2. A fall in (W/P) raises employment in part 4. The direct relation between P and Y is
(a) and (b) from L1 to L2. captured by the AS curve of part (c).
The demand curve for labour is shown in part (a) of Fig. 13.2. Since the nominal wage W is
stuck, an increase in the price level from P1 to P2 reduces the real wage from (W/P1) to (W/P2).
The lower real wage increases labour demand from L1 to L2.

The corresponding aggregate production function is shown in part (b). An increase in the
quantity of labour demanded raises output from Y1, to Y2 Part (c) shows that an increase in the
price level from P1 to P2 raises output (and income) from Y1 to Y2.

The locus of alternative combinations of P and Y is the AS curve which is expressed by the
following equation:

Y = Y̅ + α(P – Pe)

In short, since the nominal wage is sticky, an unexpected change in the price level (P ≠ Pe)
causes a deviation of the real wage (W/P) from its target level (w). This change in (W/P) affects
the amounts of labour hired and output produced.

1.2 The Worker Misconception Model:

The worker misperception (fooling) model, presented by Friedman in 1968 (in his article entitled
“Role of Monetary Policy”, American Economic Review) is based on the assumption that wages
can adjust freely and quickly to equilibrate the labour market.

Since workers temporarily equate a rise in nominal wage to a rise in real wage, i.e., they suffer
from money illusion, unexpected movements in the price level influence labour supply. In this
model, while the quantity of labour demanded by firms depends on the actual real wage, the
quantity of labour supplied depends on the expected real wage, which is nominal wage (W)
deflated by the expected price level (Pe), i.e.,

The reason for this is that while deciding on how much labour to supply, workers know their
nominal wage but not the overall price level (P). Expected real wage can be expressed as the
product of actual real wage and a new variable P/Pe:

Here, P/Pe measures workers’ misperception of the price level. If the value of this new variable
exceeds 1, then P > Pe, i.e., actual price exceeds the expected price. If P < Pe, the converse is
true.

Now, if we substitute equation (7) in equation (6) we get:

This means that the quantity of labour supplied depends on the real wage and on worker
misperception of the price level. According to this model, an unexpected rise in the price level
makes workers feel that the real wage has gone up. But this is a false belief.
Living in a world of illusion they are induced to supply more labour at the initial real wage. This
reduces the real wage from (W/P)1 to (W/P)2 in Fig. 13.3 and raises the demand for labour from
L1 to L2. The end result is a rise in employment, output and income.

Even in this model, where workers believe (in the event of a rise in overall price level) that the
real wage is higher than it actually is, deviations of actual prices from their expected levels
induce the workers to increase their supply of labour. This, in its turn, alters the output levels of
firms.

So the equation of the short-run aggregate supply (SRAS) curve is the same as in the sticky-wage
model:

Y = Y̅ + α(P – Pe) or, Yg = Y – Y̅ = a (P – Pe).

The actual output deviates from its natural rate when the actual price level deviates from the
expected price level. Here Yg measures the output gap.

1. 3 The Imperfect Information Model:

The basic assumption of the imperfect-information model is that all wages and prices are
market-determined rather than bargain-determined. They are free to adjust in response to forces
of demand and supply in labour and commodity markets.

In this model, short-run and long-run aggregate supply curves differ because of temporary
misperceptions about movements in absolute and relative prices. See Fig. 13.4. In Fig 13.4(a) we
show changes in relative prices such as Pb/Pa, Pc/Pa, Pd/Pa, Pc/Pb, Pc/Pd etc. In Fig, 13.4(b) we
show the differences between a once-and-for-all price rise and a sustained or continuous price
rise (inflation).

The imperfect-information model is based on the assumption that each supplier in the economy
produces a single good and consumes many goods. Since innumerable goods are produced in an
economy, it is virtually impossible for suppliers to observe all prices at all times. It has to be
noted that suppliers of certain goods are consumers of other goods, i.e., they are both sellers and
buyers.

They keep a close watch on the prices of the products they sell, but it is not possible for them to
closely watch the prices of the goods they buy for consumption purposes. Due to imperfect
information, they fail to understand the difference between inflation or deflation (which refers to
the rise or fall in the overall price level) and price movements (changes in relative prices).

This confusion influences decisions about how much output to offer for sale and a positive
relation is established between the price level and output in the short run.
In case of unanticipated inflation, all the suppliers find that the prices of their goods are rising at
the same time. They all predict rationally, but wrongly, that the relative prices of the goods they
produce have risen. So they work harder and produce more. Since the actual prices exceeded
their expected levels, suppliers raise their output.

So the aggregate supply curve, which is expressed by the equation Y = Y̅ + α(P – Pe), slopes
upward from left to right. So, in this model also, Y deviates from Y̅ when P deviates from Pe.

1. 4 The Sticky-Price Model:

The sticky-price model has a micro-foundation. It is based on the pricing behaviour of firms in
large oligopolistic markets. In oligopoly, we normally find output fluctuations in the face of
fluctuating demand; we do not find short-run price adjustments when demand changes. Frequent
price changes create confusion and annoyance among regular buyers.

There is loss of goodwill. Moreover, there is the cost of changing prices. New prices are to be
printed, they are to be announced through newspapers and TV commercials and new catalogues
are to be distributed to retailers all over the country. These are all costly affairs in terms of time
lost and money spent.

The sticky price model is based on the assumption that firms have some monopolistic or
oligopolistic control over the prices of their products. So we deviate from the model of perfect
competition where a firm is a price-taker.

A typical firm’s desired price p depends on two macroeconomic variables:

(i) The aggregate price level (P): which is a weighted average of all individual prices: A high P
implies that the firm’s costs are higher. Hence higher the P, higher will be the price of the
product of any firm.

(ii) The national income of the country (Y): A higher level of income widens the market for a
firm’s product. Since marginal cost increases with an increase in the volume of production, the
greater the demand, the larger the volume of production, and the higher the firm’s desired price.

The firm’s desired price is expressed as:

p = P + α(Y- Y̅ ) … (9)

This means that the desired price p depends on the general price level and the divergence of
actual output from its level (potential/natural). The parameter a, which is positive, measures the
degree of responsiveness of a firm’s desired price to the level of aggregate output.
Diverse Price Behaviour:

Let us assume that there are two types of firms. Some have flexible prices, because they set
prices according to equation (9). Others have sticky prices, in the sense that they announce their
prices in advance on the basis of their expectation about future economic conditions, i.e., on the
basis of whether they expect the economy to speed up or slow down.

The price-fixing strategy of firms with sticky prices is expressed by the following equation:

p = Pe + α(Ye – Y̅ e) …(10)

where the superscript V denotes the expected value of a variable. If we assume, for the sake of
simplicity, that these firms expect actual output to be at its natural rate, then the last term, a(Ye –
Ye), disappears. Then these firms set the price

p = P*…(11)

This means that firms with sticky prices set their prices on the basis of what they expect Other
firms to

charge.

If we are to derive the AS curve we have to find out the overall price level in the economy, by
making use of the pricing rules of the two groups of firms. If k is the proportion of firms with
stick prices, then the overall price level is

P = kPe + (1 – k) [P + α(Y – Y̅ )] … (12)

Here kPe is the price of the sticky-price firms weighted by their proportion in the economy and
the second term in equation (12) is the price of the flexible-price firms, weighted by their
proportion. If we now subtract (1 – k)P from both sides of equation (12) we get

P – P + kP = kPe + (1 – k) P + (1 – k)a (Y – Y̅ ) – (1- k)P

Or kP = kPe + (1 – k) [a(Y – Y̅ )] … (13)

If we divide both sides by k,. we get the overall price level

P = Pe + [(1 – k) a/k] (Y – Y) … (14)

The terms in this equation may now be explained:

(ii) When Y is high, the demand for goods is also likely to be high. So firms with flexible prices
fix their prices at high levels. As a result the general price level goes up. Now the effect of output
expansion on the general price level depends on the proportion of firms with flexible prices.

Thus we see that the overall price level depends on the expected price level and on the level of
output. Now we can show the equivalence of the aggregate pricing equation (14) and the
equation of the aggregate supply curve (1).

Equation (14) can be expressed as:

Thus we convert the aggregate pricing equation into the standard form of the aggregate supply
equation, presented in three other models. Thus the sticky price model also suggests that the
deviation of output from tits full employment level is directly related to the price deviation factor
(P – Pe).

Conclusions from the Four Models

PARAGAPH While each of these four models of the upward sloping short run aggregate supply
curve is useful, it is the combination of all four that provides the most realistic picture of
aggregate supply. The conclusion drawn from these models is that, in the short run, the aggregate
supply curve is upward sloping. Again, this relationship is represented by Y = Ynatural + a(P -
Expected), where Y is output, Ynatural is the natural rate of output that exists when all
productive factors are used at their normal rates, a is sssa constant greater than zero, P is the
price level, and Pexpected is the expected price level.

summary

• In the long-run, aggregate supply is determined by real factors, such as the level of employment and the
productivity of the workforce.

• In the short-run, there may be a trade-off between reduced unemployment and rising inflation.

• Equally, rising unemployment will lead to downward pressure on inflation.

• This trade-off may arise for a number of reasons, such as sticky-wages, worker misconception, sticky-
prices, and imperfect information.

Thus the real wage is likely to be pro cyclical. It is likely to rise in prosperity and fall in depression.
The four models of aggregate supply are not incompatible with one another. They are not mutually
exclusive either. Since the real world may contain all the four types of imperfections or frictions we
cannot accept one model and reject the other three

Reference

1. https://www.investopedia.com/

2. https://www.sparknotes.com/