AGGREGATE SUPPLY IN SHORT-RUN-

Our first concept is the aggregate supply in the short run.

Let's take a few moments first to understand the concept of short run in economics.

The short run expresses the concept that an economy behaves differently depending on the

length of time it has to react to a shock.

The short run does not refer to a specific duration of time, but rather is unique to

the economic concept and variable being studied.

One guiding principle is that in the short run following an exogenous shock or change

in government policy, firms and households face certain fixed constraints to adjust.

Let's now return to the concept at hand, the short run aggregate supply.

In the short run aggregate supply in an economy, it's not fixed.

It can vary.

This is due to the fact that some of its inputs can vary, and thus can alter the level of

aggregate supply in the short run.

However, not all inputs can vary in the short run.

Some production inputs are fixed.

You may recall from the previous module how we express aggregate supply.

We typically use an economy wide production function.

This production function expresses supply as having three inputs-- economy wide capital,

economy wide labor, and economy wide total factor productivity.

Thus, in the short run, aggregate supply can vary if any of those inputs can vary.

One input that can vary in the short run is labor.

Another input that can vary is capital.

While the total capital stock is typically fixed in the short run, we will discuss the

ways in which the capital use can vary.

However, the third input, the total factor productivity or TPF is typically fixed in

the short run.

You may recall that TFP is the way an economy combines capital and labor to produce goods

and services.

It is very difficult for an economy to change its TFP in the short run.
For example, economy wide level of technology evolves over time, and cannot be adjusted

in the short run.

We typically think of the productive capacity in the economy as firms which combine capital

and labor to produce goods and services.

There are several ways in which firms can vary the production inputs.

For example, firms can vary their labor input in two ways.

The first way is to hire unemployed workers.

The second way is to induce workers to work overtime.

In a similar fashion, firms can increase the capital input in two ways.

The first way is by putting to use idle capital, such as factories and machines.

The second way is by increasing the capacity utilization of the capital stock being used.

To recap, in order to increase the aggregate supply in the short run, we need to increase

some of the inputs of production.

However, increasing the capital and labor inputs in the short run can lead to higher

costs.

For example, if when firms decide to hire more workers there are a large amount of unemployed

workers there may be a little increase in costs.

However, once there are a few unemployed workers, it would be harder to increase the labor input.

Higher wages would be needed to attract the remaining few workers or to induce employed

workers to work overtime.

This, in turn, leads to higher aggregate production costs.

In a similar fashion, when firms would like to use more capital, they may be able to first

rent idle capital.

However, once there is little idle capital left, it would be harder to increase the capital

input.

To increase it further in the short run, the firms can increase the capacity utilization

of the existing capital stock.

This, in turn, results in faster depreciation.

And this leads to higher costs.

In the short run, more aggregate supply means higher costs.

We will now try to present our analysis of short run aggregate supply graphically.
On the horizontal axis we have real GDP denoted by y.

On the vertical axis, we have the price level denoted by p.

I have graphed a schedule of aggregate supply levels and price levels based on our analysis.

Suppose that we start with aggregate supply level y1, which corresponds to price level

p1.

If we would like to increase output to y2, this would require aggregate supply costs

p2.

In other words, there is a trade off between aggregate supply and aggregate price level.

If we want higher aggregate supply, we would have to accept a higher price level.

This trade off is referred to as the short run aggregate supply curve.