No Such Thing as a Free Lunch: Principles of Economics (Part 135)

“My Decision To Leave Applied Mathematics For Economics Was In Part Tied To The Widely-held Popular Belief In The 1960s That Macroeconomics Had Made Fundamental Inroads Into Controlling Business Cycles And Stopping Dysfunctional Unemployment And Inflation.”
— Robert C. Merton —

Aggregate Demand, Aggregate Supply, and Inflation

(Part D)

by

Charles Lamson

Aggregate Supply in the Short Run

Many argue that the aggregate supply curve (or the price/output response curve) has a positive slope, at least in the short run. (We will discuss the short-run/long-run distinction in more detail later in this post.) In addition, many argue that at very low levels of aggregate output---for example, when the economy is in a recession---the aggregate supply curve is fairly flat, and at high levels of output---for example, when the economy is experiencing a boom---it is vertical or nearly vertical. Such a curve is shown in Figure 6.

FIGURE 6 The Short-Run Aggregate Supply Curve

To understand the shape of the AS curve in Figure 6 consider the output and price response of markets and firms to a steady increase in aggregate demand brought about by an increasingly expansionary fiscal or monetary policy. The reaction of firms to such an expansion is likely to depend on two factors: (1) how close the economy is to capacity at the time of the expansion, and (2) how rapidly input prices (such as wage rates) respond to increases in the overall price level.

Capacity Constraints In microeconomics, "short-run" describes the time in which firms' decisions are constrained by some fixed factor of production. Firms are constrained in the short run by the number of acres of land on their farm---the amount of land owned is the fixed factor of production. Manufacturing firms short-run production decisions are constrained by the size of their physical production facilities. In the longer run, individual firms can overcome these types of constraints by investing in greater capacity---for example, by purchasing more acreage or building a new factory.

The idea of a fixed capacity in the short run also plays a role in macroeconomics. Macroeconomists tend to focus on whether or not individual firms are producing at or close to full capacity. A firm is producing at full capacity if it is fully utilizing the capital and labor it has on hand. As we will discuss in a later post, firms may at times have excess capital and excess labor on hand---amounts of capital and labor not needed to produce the current level of output. If, for example, there are costs of getting rid of capital once it is in place, a firm may choose to hold on to some of this capital, even if the economy is in a downturn and the firm has decreased its output. In this case, the firm will not be fully utilizing its capital stock. Firms may be especially likely to behave this way if they expect that the downturn will be short and that they will need the capital in the future to produce a higher level of output. Firms may have similar reasons for holding excess labor. It may be costly, both in worker morale and administrative costs, to lay off a large number of workers.

The Fed reports on the nation's "capacity utilization rate" monthly. In December of 1990, for example, during the recession of 1990 - 1991, the capacity utilization rate for manufacturing firms was 79.3 percent. This suggests about 20 percent of the nation's factory capacity was idle. During the recessions of 1974 - 1975 and 1980 - 1982, capacity utilization fell below 75 percent. As of July 15, 2021, capacity utilization was 75.3819 percent (https://fred.stlouisfed.org/series/TCU).

Macroeconomists also focus on whether or not the economy as a whole is operating at full capacity. If there is cyclical unemployment (unemployment above the frictional and structural amounts), the economy is not fully utilizing its labor force. There are people who want to work at the current wage rates who cannot find jobs.

Even if firms are not holding excess labor and capital, the economy may be operating below its capacity if there is cyclical unemployment.

Output Levels and Price/Output Responses At low levels of output in the economy, there is likely to be excess capacity both in individual firms and in the economy as a whole. Firms are likely to be producing at levels of output below their existing capacity constraints. That is, they are likely to be holding excess capital and labor. It is also likely that there will be cyclical unemployment in the economy as a whole in periods of low output. When this is the case, it is likely that firms will respond to an increase in demand by increasing output much more than they increase prices. Firms are below capacity, so the extra cost of producing more output is likely to be small. In addition, firms can get more labor (from the ranks of the unemployed) without much, if any, increase in wage rates.

An increase in aggregate demand when the economy is operating at low levels of output is likely to result in an increase in output with little or no increase in the overall price level. That is, the aggregate supply (price/output response) curve is likely to be fairly flat at low levels of output.

Refer to Figure 6. Aggregate output is considerably higher at B than at A, but the price level at B is only slightly higher than it is at A.

If aggregate output continues to expand, things will change. As firms and the economy as a whole begin to move closer and closer to capacity, firms' response to an increase in demand is likely to change from mainly increasing output to mainly increasing prices. Why? As firms continue to increase their output, they will begin to bump into their short-run capacity constraints. In addition, unemployment will be following as firms hire more workers to produce the increased output, so the economy as a whole will be approaching its capacity. As aggregate output rises, the prices of labor and capital (input costs) will begin to rise more rapidly, leading firms to increase their output prices.

At some level of output, it is virtually impossible for firms to expand any further. At this level, all sectors are fully utilizing their existing factories and equipment. Plants are running double shifts, and many workers are on overtime. In addition, there is little or no cyclical unemployment in the economy. At this point, firms will respond to any further increases in demand only by raising prices, since they are unable to expand output any further.

When the economy is producing at its maximum level of output---that is, at capacity---the aggregate supply curve becomes vertical.

Between C and D in Figure 6, the AS curve is vertical. Moving from C to D results in no increase in aggregate output but a large increase in the price level.

The Response of Input Prices to Changes in the Overall Price Level Whether or not the economy is producing a level of output close to capacity, there must be some time lag between changes in input prices and changes in output prices for the aggregate supply (price/output response) curve to slope upward. If input prices changed at exactly the same rate as output prices, the AS curve would be vertical.

It is easy to see why. It is generally assumed that firms make decisions with the objective of maximizing profits. If all output and input prices increased 10 percent, no firm would find it advantageous to change its level of output. Why? Because the output level that maximized profits before the 10 percent increase will be the same as the level that maximizes profit after the 10 percent increase. So, if input prices adjusted immediately to output prices, the aggregate supply (price/output response) curve would be vertical.

Wage rates may increase at exactly the same rate as the overall price level if the price level increase is fully anticipated. If inflation were expected to be 5 percent this year, this expected increase might be built into wage and salary contracts. Most employees, however, do not receive automatic pay raises as the overall price level increases, and sometimes increases in the price level are unanticipated. Input prices---particularly wage rates---tend to lag behind increases in output prices for a variety of reasons. At least in the short run, wage rates tend to be slow to adjust to overall macroeconomic changes. It is precisely this point that has led to an important distinction between the AS curve in the long run and the AS curve in the short run. We will return to this distinction shortly, but for now we will assume that the AS curve is shaped like the one in Figure 6. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 538-542*

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