In the last two videos, we've been slowly building up our aggregate
demand-aggregate supply model and the whole point of us doing this is so that we can give an explanation of why we have these short run economic cycles
and we don't just have this nice steady march
of economic growth due to population increases and
productivity improvement. It's important to
realize and it's probably important to realize this
for all of what we study in micro and macro economics
that this is really just a model. In order for to use
these models, we have to make huge, huge
simplifications and you really should always view these models with a critical eye. This is just one way to view it. You might not agree with it. You might think it's
an over simplification. You might want to modify it in some way. It's very important that
you just view it only as a model and the reason
why we do that is so that we can start to
describe very, very, very complicated things with
fairly simple graphs and mathematics so that
we can get our brain around something as
complicated as the economy. Something that has hundreds
of millions of actors, each of them with tens
of billions of neurons in their brain and doing
all sorts of crazy things. We're able to distill
it down to simple lines and curves and equations. Now in the last video,
we looked a little bit at the long run aggregate supply. Aggregate supply in the long run. In the ADAS model, we
assumed that in the long run, the real productivity
of the economy really doesn't depend on price,
that price is really just a numeric thing and in
the long run, people will just adjust to producing
or the economy will just adjust to producing
what it's capable of comfortably producing. Now there's one thing
I want to stress here. This is not the maximum
productivity of the economy. You could view this as the natural; let me put it this way. You could view this as the,
so this right over here, you could view it as the natural output. Natural, the natural real
output of the economy. When I say natural, it means that there's always going to be some
inefficiencies in the economy; people are going
to be switching jobs. They might have to retrain. There's always going to
be turnover in things. Some people pass away
in a job and then they have to hire other people. There's some normal or natural rate of unemployment. In most economies, people aren't working night and day. They want to take some time off. They want to be able to rest. Because of other
interventions, there aren't perfect efficiencies in
the economy as a whole. This is just a natural
healthy level of output. There is some theoretical level of output. I'll draw that here. This is maybe some
theoretical level of output that you could maybe
view as maximum output. Maybe I'll draw it right over here. This right over here
might be maximum output. Maximum, given the population and the technology that the population has, this is some type of
theoretical thing and it would be very hard to actually quantify. People were just working all out. They weren't taking vacations. They weren't sleeping properly. Every person was working in the place that they could be the most
productive, then maybe you would have some
output over here which is kind of impossible to achieve. This is something below
that, kind of a nice healthy level of output for the economy. Now what we're going to
talk about in this video is aggregate supply in
the short run and what we're going to see is
for this model to work, for the aggregate
demand-aggregate supply model to work, we have to
assume an upward sloping aggregate supply curve in the short run. It might look something like this. It might look something
like this and obviously, it would; actually let me do it this way. Let's assume that this
is our current level of prices are sitting right over here. This is our long run aggregate supply. It's not depending on
prices; it's just a natural level of output, but in
the short run it might look something like this. I'll do it in pink. In the short run, it might
look something like this. As I'm toting it up
because obviously we can never get past that
optimal, so what's going on here, what's going on in this curve - I drew a dotted line because
it's easier for me to draw something as a
dotted line when I draw it as a straight curve.
My hand always shakes too much - so this is the
aggregate supply in the short run. We'll see we need it to
be upward sloping for this model to provide
a basis of explanation for economic cycles
and there's a couple of explanations or a couple
of, you could really view them as theories,
for why we can justify an upward sloping aggregate supply curve. The one way to think
about it and before I even justify why it could be
upward sloping, what an upward sloping curve is
saying is look, this is just when people are nicely
... They're producing at their natural rate. There's going to be
some unemployment in the economy at this level right over here. For whatever reason, this
upward curve is saying if prices go up, if prices go up, then the economy as a whole is
going to produce beyond that natural rate. Maybe it's going to bring
in people from other parts or I guess you
could say it's going to suck people in to the
labor pool who might not have been in the labor
pool to work a little bit harder. Maybe they feel they can
do a little bit better now. It might convince factories
to run a little bit longer. It might convince people
to take fewer vacations. The opposite might be
true if prices go down. An upward sloping curve
is saying that if prices, aggregate prices - Now
this isn't just prices in one good or service
- if aggregate price is going down, it's saying
in the economy as a whole people might be incented
to work a little bit less. People might drop out of the labor pool. In the short run, remember
this is all in the short run, they might drop
out of the labor pool. They might not run
their factories all out. They might take more
vacations, whatever else. Now let's think about what our plausible justifications for an
upward sloping aggregate supply curve. The first one is often
called the misperception theory; let me write it in white. It's the misperception
theory and it kind of makes sense to me that if the
aggregate; let's think about a situation where
the aggregate prices are going up. Aggregate prices are going up. If I'm an individual
actor there, maybe I run a firm of some kind, I
might not notice immediately that it's aggregate
prices that are going up. I might just think that
prices for my goods or services are going up. I might think that it's actually a micro economic phenomenon going on. I'm misperceiving it
as a micro phenomenon. That's something that's
going on in my market. If I think and this goes
back to the micro economics, if I think that prices for
my goods and services are going up relative to others and remember this is a misperception, all prices are going up,
but if I think this is happening in the short run then the law of supply kicks in. Then the law of supply kicks in which is a micro economic concept that if I feel that real prices - And it's
not real prices. It's actually nominal prices
- but if I think my relative prices are
increasing, I'm motivated to produce more. I think I'm going to be more profitable. It only takes a little
bit of time for me to realize that all my costs are going up, what I can purchase
with my profits are all going up. In real terms, I'm actually
not getting any better and then I'll probably
settle in back to my regular level of productivity. While I think people are
demanding more of Sal's sprockets or whatever
I'm seeing, I'll start working over time. I might want to hire more
people, run the factories beyond even a level that
I might defer maintenance so that I can run the
factories longer and all the rest, but then over
time I'm going to realize that I was just misperceiving things. Everything has gotten more expensive. I'm not making in real
terms an outsized profit right now. Then my level of productivity
might actually go back. When I talk about me,
it's not me by myself that's moving this whole economy. Remember I'm just talking
about one actor, but this might be true of many,
many, many actors in acting in aggregate so
as a whole, they might want to increase productivity
and then when they realize that in real
terms they're actually not making any more money and that this isn't sustainable, they'll go
back to their natural level of output. The other theory that you'll read about in economic textbooks, another
theory or explanation or justification why
we would have an upward sloping aggregate supply
curve in the short run is sometimes it's called
the sticky wages theory. Sticky wages. I like to extend it to sticky cost theory. Sometimes they'll
articulate a separate one called sticky prices,
but in my mind these are all very similar, so sticky
wages, sticky costs and sticky prices. Sticky, sticky prices. It's the general idea
that even if in aggregate prices are increasing,
so in the whole economy prices are increasing, in
all parts of the economy they all won't increase at the same rate. There are parts of the economy where the prices might
be stickier than other places and there's multiple reasons why prices could be sticky. You could have wage
contracts or people might just be slow to realize
prices are going up and then renegotiating their contracts. You might have long term
agreements with suppliers that you're going to
pay a fixed price over some period of time. You've already agreed for the next year to pay it so even if aggregate prices are going up, it's
going to take a while in different parts of the
economy, for contracts or for transactions in
those parts of the economy, to actually reflect those things. Another reason why in
parts of the economy you might not have everything
move in tandem or everything move as quickly
as you would expect is because of something called menu costs. Menu costs. Menu costs are just the
idea that if prices are changing, if prices move
up in the next hour 5%, it's not actually trivial to increase your prices by 5%. For example, if you were
running a restaurant, you would have to reprint
new menus, so that's where the name comes from,
but it's not just true of a restaurant; it's true of anything. It would be true if you're
any type of supplier. You would have to change your brochures. You might have to change
your computer systems. You have to do a ton of
things to actually make things; you have to tell your sales force how the pricing might be different. There's a ton of things
that you have to do to actually change costs. These menu costs actually
might slow down the ability for all prices to move in tandem. Some of them will be
stickier than others and the reason why this is can be a rationale for an upward sloping
aggregate supply curve in the short run is if I'm in one of these industries, let's say
my sales I am able to raise the prices but
let's say the wages and my costs are sticky. I've already got into a
long term wage contract and all my suppliers
can't raise their prices as fast, so in the short
run I'm going to say gee, I'm making a lot of profit now. Even in real terms
because my costs are being relatively sticky, while
the money that's coming in the door I'm able
to raise the prices so I'm going to produce more. I'm going to run the factories longer. Maybe I'll defer maintenance so that I can produce more. Maybe I'll try to hire
more people under these agreements. Maybe I'll try to buy
more goods and services under these long term costs. The reason why I say
these are really the same side of the same coin
is you can imagine here you have company A that
is able to increase its prices so its revenue
starts going up and let's say its supplier is company B. It's company B and this
right over here is sticky. This is sticky. Maybe A buys lemons from B and then sells lemonade. It's able to raise the price of lemonade, but it has a fixed price
contract on the lemons in the short run. Eventually that will expire,
in the long run B will be able to renegotiate it upwards. A's costs are sticky, but this is B's prices are sticky. These are really the same
thing that one's costs are really the other's prices.