Explain why the short-run aggregate supply curve is not vertical, but the long-run aggregate supply curve is vertical. (6 Marks)Why do wage increases along with increases of other input prices impact...

Nicole Becker - Assignment 2
Lessons 4 & 5
Solution 1
Aggregate supply refers to the ability of an economy to produce goods and services in the
short run or long run. The nature of relation between the Aggregate supply (AS) and price level
differs in the short run and in the long run. In the short run the positive relation between AS and
the price level is given by the following figure:
The theory also suggests that the same relation does not hold in the long run. Long run
aggregate supply curve (LASC) is generally vertical. This implies that the supply is not affected
y changes in price level in the long run. The following diagram gives the relation between AS
and price level in the long run.
There are two main reasons why the AS is not vertical in the short run:
 In economic analysis, the two main factors of production are capital and
labor. In the short run it is usually assumed that the firms can increase output by
employing more labor which is the variable factor. Thus the decision to increase output in
the short run will be influenced by the wage rates. Assuming that the wage rates remain
constant, with rise in market prices the firm’s profit margins would rise. Thus the firms
would be willing to increase output levels to take away the profits.
 Also in the short run at low levels of demand, the fixed factors of the firms
usually remain underemployed. Thus if there is a market opportunity like rise in prices
due to increase in demand or other factors, the firms would utilize the excess capacity of
their fixed assets. This would help to
ing down per unit fixed costs and enjoy
economies of scale at the same time.
 Another reason could be misperception about price rise on the part of the
workers. Due to lack of perfect information, the workers agree to work for a higher wage
though the increase in general price level is more than the increase in wages. Thus their
eal wages actually fall. With fall in real wages, the firms have an incentive to employ
more labor. Hence the AS curve is upward sloping in the short run.
The LASC is vertical as the economists believe that the demand side factors
cannot influence supply in the long run. This analysis if based on the assumption that
factors are fully employed in the long run. Thus only technological advancements can
increase the production capacity of the economy. Any increase in the price level due to shift
in AD will have no effect on the AS. This can be understood by the following diagram:
As the demand shifts from AD1 to AD2, there is no change in equili
ium output of
the economy. Thus the supply curve is upward sloping in the short run and vertical in the
long run.
Solution 2
In economics theory, short run is the time period when only some factors of
production are variable. While the firms can change their employment level of labor force
and other variable inputs to maximize profits, some factors are fixed and their level of
employment remains constant. With rise in the wage rates or in the prices of variable factor
inputs, it is expected that the firms would reduce their employment level. Thus their output
levels would fall and the Aggregate supply in the economy will fall. Thus in the short run,
the effect of rise in wage rates in the labor market would cause the AS curve to shift
leftwards. Due to reduced supply in the markets, the prices would gradually rise due to
excess demand. This rise in prices would encourage the firms to increase their level of
operations. Thus they would resume the employment of workers even at the high wage rates.
Thus in the long run, the equili
ium output will remain unchanged. Rise in wage rates will
ultimately cause rise in price level and vice versa in the long run. The economy will go back
to the long run equili
ium where the supply is independent to demand side changes. Any
price shock will not cause a change in the aggregate supply in the long run. A reduction in
long run supply can be caused due to a permanent reduction in the supply of inputs which
will reduce the production capacity of the economy as a whole.
Solution 3
The macroeconomic theories suggest that the AS is positively related to price level in
the short run. With rise in prices, the producers are expected to increase their output. Also
some new players are expected to enter the markets to take advantage of the price rise. Thus
the overall supply is expected to rise in the short run. Following are some theories which
provide the rationale behind this short run phenomenon of upward sloping AS curve:
The sticky Wage theory: This theory suggests that the wage rates do not adjust
frequently with changes in the commodity prices in the short run. This is due to the reasons
like employment contracts, lack of perfect knowledge, large scale unemployment in the
economy etc. For an economy which is...