Short run aggregate supply

in the last few 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 improvements but it's important to realize and it's probably important to realize this for all of what we study in micro and macroeconomics that this is really this is really just a model and in order to do to use these models we had to make suit huge huge simplifications and you really should always view these models with a critical eye that this is just one way to view it you might not agree with it you might think it's an oversimplification you might want to modify it in some place so 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 studied we looked a little bit at the long-run aggregate supply aggregate supply in the long run and in the a das model we assume that in the long run the real productivity of 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 is capable of comfortably producing now there's one thing that I want to stress here this is not the maximum productivity of the economy this is 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 and 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 people are obviously some people pass in a job and then they have to hire other people there's some normal or natural rate of unemployment most in most economies people aren't working night and day they want to take some time off they want to be able to rest that there's because of other interventions there aren't perfect efficiencies and the economy as a whole so this is kind of just a natural healthy level of output there is some theoretical level of output maybe we could I'll draw it out here so this is maybe some theoretical level of output that you could view as maximum output and maybe I'll draw it right over here so 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 this is if people were just working all out they weren't taking vacations they weren't sleeping properly they weren't you know every every person was working in the put in the place that they could be the most productive then maybe you you would have some output over here which is kind of impossible to achieve so 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 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 so it might look something like this might look something like this and obviously obviously it would and actually let me do it this way let's assume 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 just kind of 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 and I'm asymptoting it up because obviously obviously we can never get past that optimal so what's going on here what's going on in this curve so let me I drew it a dotted line because easier for me to draw something as a dotted line that when I draw it as a straight curve I my hand always shakes too much this is the aggregate supply in the short run and we'll see we need it to be upward sloping for this model to to to 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 and the one way to think about it and before I even justify why it could be upward sloping when an upward sloping curve is saying it's like look this is just when people are you know nicely you know they're they're producing at their natural rate there's going to be some unemployment in the economy at this level right over here but for whatever reason this upward curve is saying that if prices go up if prices go up then then the economy as a whole is going to produce beyond that natural rate so maybe they're going it's going to bring in people from the from from other parts or I guess you could say it's going to suck people into the labor pool who might have not 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 to run a little bit longer it might convince people to take a few of fewer vacations then the opposite might be true if prices go down upward sloping curve is saying that if prices aggregate prices now this isn't just pricing in one good or service if aggregate prices going down it's saying in the economy as a whole people might be incentive 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 are plausible justifications for an upward sloping aggregate supply curve so the first one is often called the misperception theory let me write it in white so it's the Mis misperception theory and this is and it kind of makes sense to me that if the aggregate let's think about the situation where aggregate prices are going up aggregate prices are going up if I'm an individual actor there may be 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 so I might think that is actually a micro economic phenomenon going on so I miss perceiving it as a micro phenomenon as something that's going on in my in my market so if I think and this goes back to the microeconomics 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 actually nominal prices but if I think my relative prices are increasing I have I have I'm motivated to produce more I think I'm going to be more profitable it only takes a little bit time for them you realize that all my costs are going up what I can purchase with my profits are all going up so in real terms I'm actually not getting any better and then I'll probably settle in I'll settle back to my level regular level of productivity so while I think people are demanding more of Sal's sprockets or whatever I'm saying else I'll start working overtime I might want to suck I might want to hire more people run the factories beyond kind of a you know even a level I might 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 it was all I was just miss perceiving things everything has gotten more expensive I'm not making in real terms an outsized profit right now and then my and then so my level of productivity might actually go back and 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 this might be true of many many many actors and acting in aggregate so as a whole they might want to increase productivity and then when they realize that in real terms are actually not making any more money and and that this isn't sustainable they'll go back to their natural level of output the other theory that you will 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 sticky cost theory and sometimes they'll articulate a separate one called sticky prices but in my mind these are all very similar so stick wages to key cost and sticky prices sticky sticky prices and it's the general idea and that even if in aggregate prices are increasing so 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 and then another reason why in parts of the economy you might not have everything move kind of in tandem or everything move as quickly as you would expect is because of something called menu costs menu cost and menu costs are just the idea that if prices are changing if prices chain move up in the next hour five percent it's not actually trivial to increase your prices by five percent for example if you're 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 you'd 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 tell your sales force how the new pricing might be different so there's a ton of things that you have to do to actually change costs so these menu costs actually might slow down the ability for all prices to move in tandem so some of them will be stickier than others and the reason why this 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 that let's say my my sales I am able to raise the prices but let's say that the wages and my costs are sticky I've already I've already got into a long term wage contract and the I've already on my suppliers or 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 these are 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 try to produce more I'm going to try 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 and the reason why I say that these are really the same side of the same coin is you can imagine here you have here you have company company a that is able to 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 so a buys 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 can be B will be able to renegotiate it upwards but A's costs are sticky but this is B's prices are sticky so these are really the same thing that one's costs are really the others prices