Chapter 10: Problem 24

Briefly explain the reason for the near-horizontal shape of the SRAS curve on its far left.

Short Answer

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The near-horizontal shape of the SRAS curve on its far left is attributed to the rigidity in input prices and wages, excess capacity in the economy, and output flexibility. In this region, firms can increase production without facing significant cost increases, easily utilizing excess capacity and adjusting output levels without much impact on input prices and wages. As a result, the SRAS curve remains near-horizontal in this region.

Step by step solution

Introduction to the SRAS curve

The Short-Run Aggregate Supply (SRAS) curve represents the relationship between the overall price level and the quantity of goods and services produced by firms in an economy in the short run. The curve is generally upward sloping, meaning that as the overall price level increases, the quantity of goods and services supplied also increases. However, in a certain region near its starting point on the far left, the SRAS curve appears to be near-horizontal.

Rigidity in input prices and wages

The near-horizontal shape of the SRAS curve on its far left can be attributed to the rigidity in prices of production inputs (such as raw materials and labor wages) in the short run. At very low levels of output, producers may still be capable of increasing production without experiencing significant cost increases, either because they have under-utilized resources or they can easily access unutilized resources. Thus, the production costs do not rise considerably as output initially increases, resulting in a flat SRAS curve on the far left.

The presence of excess capacity

Another factor contributing to the near-horizontal shape of the SRAS curve on its far left is the presence of excess capacity in the economy. In a recession or in times of low demand, firms may have under-utilized capacity, as they are not producing goods at their full potential. When overall demand in the economy increases initially, firms can increase production without experiencing significant increases in costs by utilizing their excess capacity. This leads to the near-horizontal shape of the SRAS curve in that region.

Output flexibility

Lastly, the near-horizontal shape of the SRAS curve on its far left can be attributed to firms' output flexibility. When the economy is producing at a low overall level, firms can easily adjust their production levels upward to meet the increase in demand without facing rising input costs or labor wages. As a result, the SRAS curve remains near-horizontal in this region. In conclusion, the near-horizontal shape of the Short-Run Aggregate Supply (SRAS) curve on its far left can be attributed to the rigidity in input prices and wages, the presence of excess capacity in the economy, and the firms' output flexibility. In this region, firms can increase production without facing a significant rise in input prices and wages, resulting in a near-horizontal SRAS curve.

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Key Concepts

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

Aggregate Supply

Understanding the concept of aggregate supply is crucial for comprehending how an economy operates. In economics, aggregate supply (AS) refers to the total output of goods and services that producers are willing and able to supply at a given overall price level in an economy. It is closely linked to levels of capital, labor, technology, and the state of economic resources.

In the short run, factors such as existing contracts, input prices, and other rigidities influence the Short-Run Aggregate Supply (SRAS) curve. This curve is typically upward sloping because, as the price level increases, firms are incentivized to produce more due to the higher profits available. However, when production is low, firms with existing capacities can increase production without a corresponding rise in input costs, resulting in a near-horizontal SRAS curve. This reflects the economic principle that in the short term, companies can often adjust to changes in demand with little changes in price level.

Price Level and Output

The relationship between price level and output in an economy is a key dynamic that is graphically represented by the SRAS curve. The price level is the average of current prices across the entire spectrum of goods and services produced in the economy. Output refers to the quantity of goods and services produced.

When the price level rises, the purchasing power of money falls, leading consumers to spend less—this is called the ‘wealth effect’. Conversely, higher prices often mean more revenue for producers, which can lead to increased output if businesses respond by ramping up production. This relationship is not linear, though. At very low levels of output, the SRAS curve is near-horizontal, suggesting that increases in the price level do not lead to a significant increase in output since firms are not constrained by input prices or capacity. It's only as the economy approaches its productive capacity that output becomes more sensitive to the price level, causing the SRAS curve to slope upward.

Economic Fluctuations

Economic fluctuations, also known as business cycles, manifest as the expansion and contraction of economic activity over time. During these periods, key economic indicators such as GDP, employment rates, and the price level fluctuate, reflecting the changes in aggregate demand and aggregate supply within the economy.

The SRAS curve helps to illustrate the changes in output and the price level during these short-term fluctuations. When the economy experiences a downturn, resulting in low demand and output, the curve is near-horizontal. This suggests that stimulus measures to increase aggregate demand may increase output without causing inflation. However, during boom periods when output is high, increases in aggregate demand may primarily result in inflation rather than a substantial rise in output, as the SRAS curve steepens. Understanding this curve helps policymakers and economists navigate through economic fluctuations, aiming to stabilize the economy by managing aggregate demand.