Problem 21 What is the economic reason why ... [FREE SOLUTION]

Chapter 24: Problem 21

What is the economic reason why the SRAS curve slopes up?

Short Answer

Expert verified

The short-run aggregate supply (SRAS) curve slopes upward due to several factors, including labor and production cost stickiness, expectations about future price levels, capacity utilization, and the impact of supply shocks on production costs. In the short run, higher price levels lead to higher profit margins, encouraging firms to increase output. Additionally, firms tend to raise their prices when they expect overall price levels to rise, further incentivizing them to boost production. Increased capacity utilization and positive supply shocks also contribute to the upward slope of the SRAS curve by making it more profitable for firms to produce and supply goods and services at higher price levels.

Step by step solution

1. Understanding SRAS curve

The short-run aggregate supply (SRAS) curve represents the relationship between the overall level of prices in the economy and the aggregate output (real GDP) firms are willing to produce, keeping all other variables constant. In the short run, the SRAS curve has an upward slope, which means that higher price levels lead to an increase in output.

2. Labor and production costs

One of the main reasons for the upward slope of the SRAS curve is that labor and production costs tend to be sticky in the short run. When the price level in the economy increases, the nominal wages (the monetary income received by workers) don't immediately adjust, which means that firms face higher profit margins. As a result, they have a greater incentive to increase their output, which in turn pushes up the SRAS curve.

3. The role of expectations

Another factor contributing to the upward slope of the SRAS curve is the role of expectations. When producers expect the overall price level to rise, they tend to increase their prices as well, which in effect increases their profits. This also incentivizes firms to increase their output. Therefore, the increase in overall price level leads to an increase in output, resulting in an upward slope of the SRAS curve.

4. Capacity utilization

Higher levels of output can be achieved by utilizing more capacity in the production process. In the short run, when firms see that they can make more profit at a higher price level, they have an incentive to put their unused capacity to work and increase production. This allows companies to generate higher revenues and meet the increased demand for goods and services, which ultimately leads to an upward-sloping SRAS curve.

5. Supply shocks

Finally, supply shocks can also lead to an upward slope of the SRAS curve. A positive supply shock (e.g., a decrease in the price of a key input in the production process, such as oil) results in a decrease in production costs. This leads firms to produce more since they can now produce goods at lower costs, making it more profitable to do so. The increased output at a given price level causes the SRAS curve to shift upward. In conclusion, the SRAS curve slopes upward due to labor and production cost stickiness, expectations about future price levels, capacity utilization, and the impact of supply shocks on production costs. These factors encourage firms to produce more when the overall price level increases, resulting in a positive relationship between the price level and real GDP.