Aggregate Supply: Models of Aggregate Supply

Introduction to Aggregate Supply Models

The aggregate supply curve shows the relationship between the price level and output. While the long run aggregate supply curve is vertical, the short run aggregate supply curve is upward sloping. There are four major models that explain why the short-term aggregate supply curve slopes upward. The first is the sticky-wage model. The second is the worker-misperception model. The third is the imperfect-information model. The fourth is the sticky- price model. The following headings explain each of these models in depth. As we move on to explore each of these four models, keep in mind that an upward sloping short run aggregate supply curve means that as the price level rises, output increases. This is the point of each of the following models.

Sticky-Wage Model

The sticky-wage model of the upward sloping short run aggregate supply curve is based on the labor market. In many industries, short run wages are set by contracts. That is, workers are paid based on relatively permanent pay schedules that are decided upon by management or unions or both. When the economy changes, the wage the workers receive cannot adjust immediately.

Given that wages are sticky, the chain of events leading from an increase in the price level to an increase in output is fairly straightforward. When the price level rises, the nominal wage remains fixed because this is solely based on the dollar amount of the wage. The real wage, on the other hand, falls because this is based on the purchasing power of the wage. A higher price level means that a given wage is able to purchase fewer goods and services.

PARAGAPH When the real wage that firms pay employees falls, labor becomes cheaper. However, since the amount of output produced for each unit of labor is still the same, firms choose to hire more workers and increase revenues and profits. When firms hire more labor, output increases. Thus, when the price level rises, output increases because of sticky wages.

Let's summarize the chain of events that leads from an increase in the price level to an increase in output in the sticky-wage model. When the price level rises, real wages fall. When real wages fall, labor becomes cheaper. When labor becomes cheaper, firms hire more labor. When firms hire more labor, output increases.

Worker-Misperception Model

The worker-misperception model of the upward sloping short- run aggregate supply curve is again based on the labor market. This time, unlike in the sticky-wage model, wages are free to move as the economy changes. The amount of work that an employee is willing to supply is based on the expected real wage. That is, workers know how many dollars they are being paid, the nominal wage, but workers can only guess at how much goods and services they can purchase with this wage, the real wage. In general, the higher the real wage, the more work that workers are willing to supply.

Now let's say that the price level increases. Because we assume that firms have more information than workers do, firms will give workers a raise so that their nominal wage increases with the price level. But since the workers do not realize that the price level increased, they will believe that their real wage increased, not just their nominal wage. At a higher real wage, workers are induced to work more. When workers work more, output increases. Thus, when the price level increases, output also increases because of worker-misperception.

Let's summarize the chain of events that leads from an increase in the price level to an increase in output in the worker-misperception model. When the price level rises, firms increase nominal wages. When nominal wages increase, workers--due to misperceptions--believe that real wages also increase. When workers believe that real wages increase, workers provide more labor. When workers provide more labor, output increases.

Imperfect-Information Model

The imperfect-information model of the upward sloping short- run aggregate supply curve is again based on the labor market. In this model, unlike either the sticky-wage model or the worker-misperception model, neither the worker nor the firm has complete information. That is, neither is better informed than the other is about the real wage, the nominal wage, or the price level.

In this model, producers are considered to be really only aware of the price of the goods and services that they produce. That is, producers are unable to recognize overall increases in the price level because they are focused on their products only. Instead, producers only recognize changes in the prices of the goods and services that they produce. Given that producers are unable to recognize changes in the overall price level, they are likely to confuse changes in the goods and services they produce (relative changes in the price level) with changes in the overall price level (absolute changes in the price level).

It is important to understand the implications of both relative changes in the price level and absolute changes in the price level. When a relative change in the price level occurs, producers of some goods and services are better off because the price of their output increases to a greater extent than the overall price level. Both the real wage and the nominal wage earned by these producers increase. When an absolute change in the price level occurs, all producers are affected equally and the nominal wage increases while the real wage remains constant.

Recall that producers are willing to provide more labor when the wage is high. That is, they will work harder when they are getting paid more for their work. Also recall that producers cannot differentiate between relative changes in the price level and absolute changes in the price level. Thus, when a producer sees a change in the price level, she will likely believe that it is a relative change in the price level, even if it is an absolute change in the price level. Because of this, the producer will work more and produce more output when the price level rises. Thus, an increase in the price level causes output to rise.

Let's summarize the chain of events that leads from an increase in the price level to an increase in output in the imperfect-information model. When the overall price level rises, producers mistake it for a relative increase in the price level. When the relative price level rises, the real wage earned by producers rises. When the real wage earned by producers rises, the amount of labor supplied by producers increases. When the amount of labor supplied by producers increases, output increases.

Sticky-Price Model

The sticky-price model of the upward sloping short-run aggregate supply curve is based on the idea that firms do not adjust their price instantly to changes in the economy. There are numerous reasons for this. First, many prices, like wages, are set in relatively long-term contracts. Imagine if your wage at McDonalds changed every day as the economy changed. Second, firms hold prices stable to keep from annoying regular customers. It would really be a pain if the price of a newspaper changes from 24 cents to 25 cents to 23 cents as the price of paper and ink changed. Third, firms hold prices stable because of menu costs. Menu costs are those costs that are associated with printed catalogues and menus. It would be very expensive to constantly change catalogues and menus in response to economic changes.

But how does the fact the prices are sticky in the short run lead to an upward sloping relationship between the price level and output? When firms prepare to set their prices, they take into account the expected price level. When the expected price level is high, firms set their prices high to compensate for the high price of inputs. When the price charged for output is high firms produce more output, as the incentive for production is also high. Thus, an increase in the price level leads rather directly to an increase in output in the sticky-price model.

There is another way to conceptualize the relationship between the price level and output in the sticky-price model. When the level of output is high, the demand for goods and services is also high. Thus, when firms set their sticky- prices, they set them high to account for the high demand. When firms set their prices high, the overall price level increases. Thus, a high level of output leads to a high level of demand, which leads to a high price level.

Let's summarize the two chains of events that characterize the relationship between the price level and output in the sticky-price model. First, when firms expect a high price level they set their relatively sticky prices high. Other firms follow suit and set their prices high as well. Thus, a high expected price level leads to a high actual price level. When the expected price level is high, producers produce more output. Second, when the level of output is high, the demand for goods and services is also high. When the demand for goods and services is high, the price charged for goods and services is also high. When the price charged for goods and services is high, firms set their relatively sticky prices high. When some firms set their relatively sticky prices high, other firms follow suit. Thus, the overall price level increases.

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 - Pexpected), 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 a constant greater than zero, P is the price level, and Pexpected is the expected price level.