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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.