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Prices can be sticky, and that can explain aggregate supply in the short term in an economy. In this lesson, you'll learn about sticky price theory and how it tries to explain short term aggregate supply. A short quiz follows the lesson.
Sticky Prices and Aggregate Supply
Sticky prices are prices that do not adjust immediately to changing economic conditions.
Aggregate supply is the total quantity of goods and services produced in an economy at a particular point in time. If you plot the quantity of goods and services supplied in an economy at a particular price level and connect the dots, you'll see what is called an aggregate supply curve. In the long run, an aggregate supply curve is vertical because the quantity supplied does not depend on price level. Instead, the quantity supplied is based on the productive capacity of an economy - its labor, land, capital, and other factors of production. However, in the short run, the aggregate demand curve is upward sloping. The theory of sticky prices attempts to explain why the aggregate supply curve is upward sloping in the short run.
Short-Term Aggregate Supply
Some economists argue that the aggregate supply curve is upward sloping in the short term because of sticky prices. As we discussed, a sticky price is the tendency of the price for a certain good or service to not respond instantly to changes in the economic situation. Part of the slow response is due to menu costs, which are costs related to changing prices. Menu costs can include such things as printing costs, distribution costs, and the time and labor required to change price tags.
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An unanticipated drop in prices may result in some businesses temporary stuck with prices higher than the optimal level because they are unwilling to bear the menu costs associated with changing the prices. On the other hand, some businesses probably will adjust prices immediately. The businesses with prices that are too high will suffer a drop in sales. The drop in sales induces businesses to reduce the quantity of the products and services they produce. Thus, in the short term, the price level of a good or service can affect supply.
Sticky prices are prices for goods and services that do not respond immediately to changing economic conditions and have been used to explain the shape of the short-term aggregate supply curve. Aggregate supply is the total quantity of goods and services produced in an economy at a particular point in time.
In the long run, an aggregate supply curve is vertical because supply is not affected by price in the long term. However, in the short term, menu costs prevent some sellers from immediately adjusting prices, which cause them to suffer a decline in sales. The decline in sales induces these sellers to reduce the quantity supplied in the short term. Consequently, in the short term, price can affect aggregate supply.
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