— Tyler Cowen —
Aggregate Demand, Aggregate Supply, and Inflation
(Part C)
by
Charles Lamson
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The Aggregate Supply Curve
Aggregate supply is the total supply of goods and services in an economy. Although there is little disagreement among economists about the logic behind the aggregate demand curve, there is a great deal of disagreement about the logic behind the aggregate supply curve. There is also disagreement about its shape. The Aggregate Supply Curve: A Warning The aggregate supply (AS) curve shows the relationship between the aggregate quantity of output supplied by all the firms in an economy and the overall price level. To understand the aggregate supply curve, we need to understand something about the behavior of the individual firms that make up the economy. It may seem logical to derive the aggregate supply curve by adding together the supply curves of all the individual firms in the economy. However, the logic behind the relationship between the overall price level in the economy and the level of aggregate output (income)---that is, the AS curve---is very different from the logic behind an individual firm's supply curve. The aggregate supply curve is not a market supply curve, and it is not the simple sum of all the individual supply curves in the economy. (Recall from part 132 a similar warning for the aggregate demand curve.) To understand why, recall the logic behind a simple supply curve. A supply curve shows the quantity of output an individual firm would supply at each possible price, ceteris paribus. When we draw a firm's supply curve, we assume that output prices, including wage rates, are constant. An individual firm's supply curve shows what would happen to the firm's output if the price of its output changes with no corresponding increase in costs. Such an assumption for an individual firm is reasonable because an individual firm is small relative to the economy as a whole. (It is unlikely that one firm raising the price of its output will lead to significant increases in input prices in the economy.) If the price of a profit-maximizing firm's output rises with no increase in the costs of any influence, the firm is likely to increase output.  What would happen, however, if there were an increase in the overall price level? It is unrealistic to believe that costs are constant for individual firms if the overall price level is increasing, for two reasons. First, the outputs of some firms are the inputs of other firms. Therefore, if output prices rise, there will be an increase in at least some input prices. Second, it is unrealistic to assume that wage rates (an important input cost) do not rise at all when the overall price level rises. Because all input prices (including wage rates) are not constant as the overall price level rises. Because all input prices (including wage rates) are not constant as the overall price level changes, individual firms' supply curves shift as the overall price level changes, so we cannot sum them to get an aggregate supply curve. Another reason the aggregate supply curve cannot be the sum of the supply curves of all the individual firms in the economy is that many firms (some would argue most firms) do not simply respond to prices determined in the market. Instead, they actually set prices. Only in perfectly competitive markets do firms simply react to prices determined by market forces. Firms in other kinds of industries [imperfectly competitive industries (industries in which individual firms have some control over the price of their output), to be exact] make both output and price decisions based on their perceptions of demand and costs. Price-setting firms do not have individual supply curves because these firms are choosing both output and price at the same time. To derive an individual supply curve, we need to imagine calling out a price to a firm and having the firm tell us how much output it will supply at that price. We cannot do this if firms are also setting prices. If supply curves do not exist for imperfectly competitive firms, we certainly cannot add them together to get an aggregate supply curve. What can we say about the relationship between aggregate output and the overall price level? Because input prices change when the overall price level changes and because many firms in the economy set prices as well as output, it is clear that an "aggregate supply curve" in the traditional sense of the word supply does not exist. What does exist is what we might call a "price/output response"---a curve that traces out the price decisions and output decisions of all the markets and firms in the economy under a given set of circumstances. What might such a curve look like? The answer to this question is where we turn our attention in the next post, where we discuss aggregate supply in the short run.  *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED.,. PP. 538-539* end |
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