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Aggregate Supply Curve: Definition & Overview

Aggregate Supply Curve: Definition & Overview
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  • 0:02 Definition of…
  • 0:20 Vertical Long Run of Slope
  • 2:03 Upward Sloping in Short Run
  • 4:18 Shifts in Aggregate…
  • 6:32 Lesson Summary
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Lesson Transcript
Instructor: Shawn Grimsley
Economists often analyze the total supply of goods and services provided by businesses on an economy-wide basis. In this lesson, you'll learn about the aggregate supply curve, including key concepts related to it.

Definition of Aggregate Supply Curve

An aggregate supply curve shows the quantity of all the goods and services that businesses in an economy will sell at a particular price level. In the long run, the aggregate supply curve is vertical, but the aggregate supply curve will be upward sloping in the short run.

Vertical Long Run of Slope

As said earlier, the aggregate supply curve is completely vertical in the long run. You're probably asking yourself why. The total production of goods and services in an economy is its real gross domestic product (GDP). In the long-run, GDP depends on the supply of labor, capital, land, natural resources, and the availability of technology to turn these resources into goods and services. In the long run, these factors of production determine the quantity of goods and services that are supplied in an economy. This quantity is the same regardless of a price level.

But, you may be asking yourself why the supply curves for individual goods or services are upward sloping instead of vertical. The upward slope of the supply curve for specific goods or services has to do with relative prices, which are simply the prices of goods and services compared to other goods and services. A business can take advantage of relative prices to increase production of a specific good or service.

Let's say that you own an industrial bakery where you mass-produce donuts and cinnamon rolls. The market price of donuts has increased. Assuming that the other prices in the economy remain constant, you can shift your labor and ingredients away from production of cinnamon rolls to donuts. In contrast, an entire economy's production is limited by available labor, capital, land, and natural resources. When prices rise at the same time in economy, there can be no change in the overall quantity of goods or service produced; you can shift production around, but the numbers remain the same because we are dealing with aggregates.

Upward Sloping in Short Run

In the short run, the aggregate supply curve will react to price level, which means it is upward sloping rather than vertical. If the price level increases, quantity supplied will increase. If the price level decreases, the quantity supplied will decrease. Economists have offered three theories to explain this positive relationship between price and quantity creating an upward sloping curve in the short run. Let's take a brief look at each.

Sticky-wage theory: According to this theory, the short-run aggregate supply curve is upward sloping because wages take time to adjust to changes; wages are sticky. According to the theory, during the time it takes wages to adjust to a lower price level, production becomes less profitable, and businesses reduce supply as a result. For example, a union contract may be in effect for three years with a wage based upon anticipated profits. However, if the profit margin goes down because of a decrease in price, the business is stuck by contract with paying the same wages. It will respond by temporarily reducing the quantity supplied until the wages become unstuck.

Sticky-price theory: The rationale behind sticky-price theory is the same as the sticky-wage theory but with regards to price of the good provided. Menu costs create stickiness in prices because of the costs and time required to change the price, such as costs of printing new sales materials and distributing catalogs and the time required for a retailer to change price tags. Businesses will temporarily reduce the quantity supplied until they can get prices unstuck.

Misperception theory: This theory holds that when a seller sees the price of its products decline, it makes an erroneous assumption that their relative prices have also declined. This misperception tends to induce sellers to supply less quantity to the market. For example, a dairy farmer may see a decline in the price of milk before he or she sees a price decline of many other products at the grocery store. The dairy farmer is induced by this misperception that only the price of milk is in decline to temporary reduce the supply of milk until the perception is corrected.

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