Just as the negative slopes of Aggregate Demand curves resemble those of market demands, the positive slopes of Aggregate Supply curves mirror those of market supplies.

The Aggregate Supply curve reflects a positive relationship between the price level and the real quantity of national output.

The foundations of Aggregate Supply curves have some parallels in the foundations of market supply curves, but there are also some major differences.

Slope of the Aggregate Supply Curve

The general law of diminishing returns partially accounts for the upward slope of supply curves for individual firms and for market supply curves. Additional production eventually becomes ever more costly as output levels grow. Thus, firms may require higher prices to justify expanding their outputs. Moreover, higher prices embody greater incentives for firms to produce more output because profit opportunities are enhanced. A similar logic applies for the economy as a whole.

"  Capacity and Price Cost Dynamics  The positive slope of the Aggregate Supply curve in Figure 7 reflects the fact that prices adjust more rapidly than production costs; costs are relatively more  sticky. When the price level rises, delayed hikes in costs yield profit incentives to expand production.

 

Idle resources become less available when higher employment presses against a society s productive capacity. The prices a firm can charge in a growing economy tend to rise faster than its resource costs. Thus, profit per unit of output grows during a business upturn. Firms naturally respond by producing and selling more goods. But prices tend to fall faster than costs when business activity slows down, and profit per unit of output may even become negative. Firms facing declining profit margins may drastically cut back production and lay off workers to cut their costs.

 

For example, an increase in the demand for food at your local supermarket would cause movement along its supply curve. The manager will order more goods and quickly mark up prices. Grocers will also hire more workers. Employees wages and other costs will rise, but much less rapidly than prices, so total profits will swell. What happens if this demand collapses? The prices the grocer charges will fall much faster than wages or other production costs. Profits plummet, so grocery workers will lose their jobs.

 

Conclusion? Production costs per unit are much slower to adjust to changes in Aggregate Demand than are the prices of output. This is the major reason why a society s Aggregate Supply is positively sloped in the short run, as shown in Figure 7.

 

 

"  National Output and the Work Force  
National output expands when more workers become employed, but because of diminishing returns, beyond some point, extra workers decreasingly add to total output. Labor markets are based on supply and demand, much like markets for goods. Higher wages may induce greater effort or attract more people into the labor force, or the unemployed may find acceptable positions after shorter periods of joblessness. Thus, unless the economy is extremely slack, supply curves for labor have a positive slope.

 

When aggregate output is low and unemployment is high (output below Qf in Figure 7), economic slack allows most firms to expand output without incurring higher average costs; upward pressure on prices is minimal. As the economy approaches its capacity (Qf), additional output becomes increasingly costly, pushing prices up sharply. Classical theory relies on market forces to automatically drive an economy to full employment. Output levels ultimately depend on resources and technology, not on the price level per se. Thus, classical economics predicts a vertical long-run Aggregate Supply curve. Keynesian theory, on the other hand, deals best with depressed economies plagued by so many idle resources that the short-run Aggregate Supply curve is horizontal. Consequently, the Aggregate Supply curve is positively sloped when the economy operates between the extremes of classical full employment and a severe Keynesian depression, as shown in Figure 7.

 

In summary, rising employment and output levels generate pressure for hikes in wages and prices, while falling employment and output create pressure for wage and price cuts.

        Shifts in Aggregate Supply

Aggregate Supply is determined by how technology is used to combine the available quantities and qualities of labor, land, capital, and entrepreneurship, ultimately determining productive capacity and costs. Our discussion of shifts of Aggregate Supply curves opens with a quick review of the influences on market supply curves detailed in Chapter 3. In addition to price, the major determinants are (a) resource costs, (b) production technology; (c) expectations, (d) taxes or subsidies or regulations on producers, (e) the prices of other producible goods, and (f) the number of producers in the market.

 

Changes in influences other than its own price cause a good s market supply to shift. An Aggregate Supply curve, however, encompasses all outputs, all producers, and an average of all domestic prices (the price level). Thus, because substitutions between various domestic outputs tend to be offsetting, we will ignore changes in the prices of other producible goods. We are left with (a) the costs and availability of resources, (b) technology, (c) expectations, and (d) government policies as the four major shifters of the Aggregate Supply curve.

"  Resource Costs  
Production absorbs resources, so any shock boosting resource costs reduces Aggregate Supply. As resource costs (e.g., wages for labor) climb, Aggregate Supply falls (shifts leftward), and vice versa. Labor supplies depend on how individuals balance income from work against their enjoyment of leisure. Today, people increasingly opt for more leisure through shorter workweeks, part-time employment, or other forms of work sharing. Growing preferences for leisure over work cause leftward shifts of labor supply curves. This shifts Aggregate Supply leftward, as shown in Panel A of Figure 8 by the shift from AS0 to AS1. Alternatively, if more people chose to work or began working longer hours, Aggregate Supply might shift from AS0 to AS2 in Panel B. Another type of labor market disturbance would occur if the power of unions grew and organized labor negotiated higher wages: Aggregate Supply would shrink.

 

Other resource costs are also important. Most oil-importing countries endured painful leftward shifts in their Aggregate Supply curves during 1973 1975 after OPEC quadrupled oil prices. Rightward shifts occur when new resources are discovered and push prices down. Discoveries of huge pools of oil in Mexico, Alaska, and the North Sea eventually created a world oil glut that drove prices down in the 1980s, boosting Aggregate Supply to the right.

 

Some costs may rise artificially if economic power becomes more concentrated. Aggregate Supply shrinks when firms that gain market power cut output to extract higher prices and profits. Alternatively, Aggregate Supply grows if competition intensifies because of (a) external firms quests for shares of monopolists profits, (b) vigorous antitrust actions, or (c) the invasion of a market by imports.

 

"  Technology  
Technological advances shift Aggregate Supply curves rightward. Microchips spun off from the space program, for example, enhanced Aggregate Supplies internationally, in part because robots do boring or repetitive tasks with less physical and mental burnout than most humans suffer. Sophisticated but cheap microcomputers have automated office work, permitting firms to grow to sizes once thought hopelessly inefficient. Such innovations permit a society to produce more from existing resources and talent.

"  Expectations  
Changing expectations about inflation or future prosperity acutely affect Aggregate Supply. For example, investors willingness to buy new machinery or to plan new construction depends on their profit forecasts. New investments enhance productivity and, consequently, Aggregate Supply.

Inflationary expectations can be especially powerful. For example, labor supply curves will shift leftward continuously if workers feel that inflation threatens the purchasing power of their earnings. If you were a union wage negotiator, your wage demands would be closely tied to your view of how rapid inflation might be over the life of a contract. Expectations of inflation shift Aggregate Supply to the left. Naturally, declining inflationary expectations stabilize labor supplies and may shift the Aggregate Supply curve to the right.

"  Government Policies  
Work versus leisure choices are influenced by taxes and social welfare policies. Suppose, for example, that income tax rates rise. Some people might try to maintain their disposable incomes by working longer and harder. Even more workers would work less, however, and some might choose not to work at all. These leftward shifts of labor supply curves occur because higher taxes make earning additional income worth less. Workers base work leisure decisions on take-home pay, not gross wages. Higher Social Security taxes or increased unemployment compensation or welfare payments may also hinder labor force participation and, thus, shift Aggregate Supply to the left.

 

Critics argue that massive growth of government regulation causes inefficiency. Some estimates suggest that complying with federal regulations absorbs between 5% and 10% of our national income.13 If inefficient new regulations (e.g., rigid wage and price controls) smother private business activity, the Aggregate Supply curve shifts to the left (a movement from AS0 to AS1 in Figure 8). Abolishing burdensome regulations shifts Aggregate Supply rightward.

 

For example, airline deregulation resulted in sharp declines in fares and the emergence of new airlines; passenger miles more than doubled after deregulation in 1978.14 On the other hand, efficient regulations expand Aggregate Supply. For example, supplies of professional services grew after the Federal Trade Commission outlawed fee-setting practices (wrapped in rhetoric about professional ethics) by the American Medical Association and American Bar Association and barred these organizations from limiting advertising by doctors and lawyers.

 

Policies that dampen incentives to introduce new technologies or to accumulate capital hamper economic growth. If policies impede technological advances and investment, the economy declines (or fails to grow as fast as it could), and the Aggregate Supply curve shifts to the left (or is held back). Government policies encouraging capital accumulation (e.g., reduced taxes on capital gains) or speeding introduction of modern equipment (investment tax credits) shift the Aggregate Supply curve to the right.

 

Government may also enhance Aggregate Supply through (a) direct funding of research and development (R&D) that advance technology, (b) subsidies or tax incentives that stimulate private R&D, or (c) patent or copyright protection. Incomes to private developers of new technologies or discoverers of basic scientific knowledge are generally less than the values of such advances to the society at large, in part because competitors quickly jump on the bandwagon whenever an innovation appears pro- fitable. Consequently, much of the basic R&D in this country is done in government laboratories (e.g., the National Institutes of Health) or through governmental funding of research projects at colleges and universities.

 

The major influences that shift Aggregate Supply are listed below Figure 8. Be sure that you understand why Aggregate Supply shifts as it does.