1
$\begingroup$

One of theories that explains why the SRAS is upward slopping is the theory of sticky prices.

For an example, suppose there is inflation. In the short run it will take different time for firms to adjust their prices. And the ones that will adjust their prices quickly will be able to rip additional short-term profit. If my inputs (raw materials, labor, etc) are slow to increase their prices, then I will be able to rip additional profit by using said inputs and then selling the outputs under prices that correspond to new price level. Theoretically people like me are responsible for upward slopping nature of the SRAS.

BUT, the coin has two sides. There are firms that have sticky prices. For an example, maybe they need to honor some kind of contract that made prices immutable for some time period. Or maybe they need approval of government officials to rise their prices and it can take time. They can't rise prices for given time period, but they will face increased demand from firms that have less stickier prices for their outputs. The only other way to reach equilibrium in their local markets in face of increased demand would be to DECREASE QUANTITY SUPPLIED. And this will happen all over the country, making the real GDP smaller.

In other words, there would be two kinds of reactions to increased price level in the short run by firms. "Flexible" firms (i.e. firms who quickly adjust prices of their goods) would increase quantity supplied (and consequently, increase real GDP), while "rigid" firms would DECREASE quantity supplied (and consequently, decrease real GDP).

Now it's not obvious why it would lead to the SRAS having uppward slope. How can we know for sure? Maybe profits received by "flexible" firms will be compensated by decreased output by "rigid" firms. Or maybe a decrease in real GDP caused by underproduction by "rigid" firms will outweight gains by "flexible" firms, leading to decreased real GDP in the short run.

$\endgroup$
  • 1
    $\begingroup$ What evidence do you have that the sticky firms will decrease quantity supplied? Unless their cost to produce is greater than the price they can sell at, I don't see why they would. They might attempt to increase volume to meet fixed expenses. Even at a temporary loss, they might make a strategic move to try to stay in the market. $\endgroup$ – Damila Feb 27 at 20:06
  • $\begingroup$ @Damila Unless marginal cost of production is constant, production of each additional unit (or bunch of units) increases cost of production. So if profit margins will fall, then it can become unprofitable to produce current amount of production $\endgroup$ – user161005 Feb 28 at 3:37
  • $\begingroup$ But if profit margins remain > 0, they might not just stop. Otherwise they have 0 income instead of some income. $\endgroup$ – Damila Feb 28 at 3:42
  • $\begingroup$ @Damila Right, they can remain >0 Or maybe they will turn negative because for some reasons (fierce competition, poor population, strict regulations,etc) profit margins were already thin in the first place. Both scenarios can happen and we don't know which one will dominate in the economy. So there is a reasonable doubt that most of "rigid" firms won't decrese quantity supplied. So we can't be sure that SRAS will be upward slopping in given economy $\endgroup$ – user161005 Feb 28 at 9:37

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Browse other questions tagged or ask your own question.