Q2. First, imagine that both input p... [FREE SOLUTION]

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Chapter 19: Q2. (page 405)

First, imagine that both input prices and output prices are fixed in the economy. What does the aggregate supply curve look like? If AD decreases in this situation, what will happen to equilibrium output and the price level? Next, imagine that input prices are fixed, but output prices are flexible. What does the aggregate supply curve look like? In this case, if AD decreases, what will happen to equilibrium output and the price level? Finally, if both input prices and output prices are fully flexible, what does the aggregate supply curve look like? In this case, if AD decreases, what will happen to equilibrium output and the price level?

Short Answer

Expert verified

When both input and output prices are fixed, the aggregate supply curve is horizontal.

If AD decreases in the above situation, the equilibrium output will decrease, and the price will remain unchanged.

When the input prices are fixed, but output prices are flexible, the aggregate supply curve is upward sloping.

If AD decreases in this situation, equilibrium output and price decrease.

When both input and output prices are flexible, the aggregate supply curve is vertical. If AD decreases in this situation, the equilibrium output remains the same, but the equilibrium price falls.

Step by step solution

When input and output prices are fixed

When the output price is fixed, any quantity will be supplied at the fixed price. So, the aggregate supply curve will be horizontal. If the AD decreases in this situation, it will shift to the left and intersect the AS curve at a lower output. Hence, the equilibrium quantity decreases. However, the equilibrium price remains the same.

When input prices are fixed and output prices are flexible

The producers would like to supply more if the prices are more and less if the prices are less. Hence, when the output price is flexible, the AS curve is upward sloping. If the AD decreases, the AD curve will shift to the left, and it will intersect the same AS curve at a lower price and quantity. Hence, the equilibrium price and quantity decrease.

When input and output prices both are flexible

When the input prices can be changed, the producers would employ all the inputs at a price suitable to them, produce the maximum amount possible, and sell it at any price according to demand. Hence, the AS curve is vertical. If the AD decreases, less output will be demanded at a lesser price. So, the input prices will shift downward, and the producers will increase the supply to the earlier potential equilibrium.