Chapter 10: Problem 21

What is the economic reason why the SRAS curve slopes up?

Short Answer

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The economic reason behind the upward slope of the Short Run Aggregate Supply (SRAS) curve can be attributed to factors such as the Law of Diminishing Marginal Returns, sticky nominal wages and input costs, and menu costs. As the price level increases, firms are incentivized to produce more due to higher profit margins. However, the law of diminishing marginal returns and sticky input costs lead to higher production costs, which result in higher prices for the produced goods and services. This interplay between increased production and rising costs leads to an upward-sloping SRAS curve.

Step by step solution

Define SRAS

The Short Run Aggregate Supply (SRAS) curve represents the total quantity of goods and services that firms in an economy are willing and able to produce at different price levels in the short run. The short run is when at least one input in the production process is fixed, such as capital or labor.

Factors contributing to an upward-sloping SRAS curve

There are several factors that can explain the upward slope of the SRAS curve: 1. The Law of Diminishing Marginal Returns: As more of a variable input (such as labor) is added to a fixed input (like capital), there comes a point when each additional unit of the variable input contributes less and less to total output. This implies that firms have to increase their use of variable inputs to maintain the same level of production, which raises their costs and, subsequently, the prices of their products. 2. Nominal wages and other input costs: As the price level increases, firms' revenues also increase. However, in the short run, nominal wages and other input costs are typically sticky, meaning they do not change immediately in response to changing price levels. This leads to higher profits for firms, incentivizing them to increase their production to take advantage of the higher profit margins. 3. Menu costs and price stickiness: Menu costs refer to the costs associated with adjusting prices, such as printing new menus or updating price tags. Due to these costs, firms may not immediately adjust their prices in response to changes in the overall price level. As a result, there may be temporary discrepancies between input prices and output prices, which can affect SRAS.

Explaining the upward slope of SRAS curve

The combination of diminishing marginal returns, sticky nominal wages and input costs, and menu costs contribute to the upward slope of the SRAS curve. As the price level increases, firms have a greater incentive to increase their production, making more goods and services available in the economy. However, due to the law of diminishing marginal returns and sticky input costs, firms face higher production costs as they try to meet the increased demand. This leads to higher prices for their products, which translates into an upward-sloping SRAS curve. Overall, the SRAS curve slopes upwards because higher price levels incentivize firms to produce more, but the associated increase in costs results in rising prices for the goods and services they produce.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Short Run Aggregate Supply

The Short Run Aggregate Supply (SRAS) curve is a fundamental concept in macroeconomics that illustrates the total output of goods and services an economy can produce at various price levels in the short term. In this period, firms' capacities are partially fixed, meaning not all resources can be adjusted right away.

For instance, while a factory can hire more workers to increase production, it cannot immediately expand its building or install new machinery. This causes a unique relationship between the price level and output, leading to the SRAS curve's characteristic upward slope: as prices increase, firms are encouraged to boost their production thanks to immediate revenue gains that exceed their relatively sticky costs.

However, the SRAS curve is not static. Economic shock or policy changes can shift the curve. For example, a sudden increase in available technology could enable more production without increasing costs, shifting the SRAS curve to the right, signaling more output at each price level.

Law of Diminishing Marginal Returns

The Law of Diminishing Marginal Returns is a principle that plays a crucial role in the shaping of the SRAS curve. It states that when additional units of a variable factor (like labor) are added to a fixed factor (such as machinery or land), the additional output generated by each new unit eventually decreases.

In practical terms, imagine adding more workers to a crowded factory floor; each new worker contributes less to total output because the space is cramped and there are only so many machines to work with. This diminishing productivity leads to an increase in the cost of producing each additional unit of good or service, which in turn contributes to the upward slope of the SRAS curve. Firms need to charge higher prices to cover these increased costs, especially as they attempt to ramp up production to meet rising demand.

Price Stickiness

Price stickiness, or the resistance of prices to change, is a phenomenon that significantly affects the SRAS curve. Despite changes in demand or supply conditions, prices often don't adjust quickly due to various frictions. One key source of this stickiness is the existence of contracts that fix prices and wages for certain periods, which prevents immediate adjustments to changing market conditions.

Furthermore, firms may avoid frequent price changes to prevent annoying customers with constant fluctuations or to maintain perceived quality and value. This inertia means that even as the economic environment shifts, prices may remain at previous levels, contributing to the sluggish adjustment of quantity supplied in the short run—an effect directly reflected in the upward slope of the SRAS curve.

Menu Costs

Menu costs refer to the costs incurred by firms when they need to change prices, not just in the literal sense of a restaurant changing its menu, but in the broader sense of any company needing to update price tags, advertising materials, or computer systems. Although seemingly minor, these costs can be significant barriers to price adjustment, contributing to the stickiness of prices.

This inertia impacts the SRAS curve because firms may be disinclined to adjust their prices in response to every shift in demand or cost change, resulting in a delay in the economy's return to equilibrium. Hence, the SRAS curve's upward slope can be seen as a reflection of the hesitation firms feel towards frequently recalibrating prices and the associated economic implications of such recalculations.