Video transcript
In the last two videos, we've been slowly building up our aggregatedemand-aggregate supply model and the whole point of us doing this is so that we can give an explanation of why we have these short run economic cyclesand we don't just have this nice steady marchof economic growth due to population increases andproductivity improvement. It's important torealize and it's probably important to realize thisfor all of what we study in micro and macro economicsthat this is really just a model. In order for to usethese models, we have to make huge, hugesimplifications and you really should always view these models with a critical eye. This is just one way to view it. You might not agree with it. You might think it'san over simplification. You might want to modify it in some way. It's very important thatyou just view it only as a model and the reasonwhy we do that is so that we can start todescribe very, very, very complicated things withfairly simple graphs and mathematics so thatwe can get our brain around something ascomplicated as the economy. Something that has hundredsof millions of actors, each of them with tensof billions of neurons in their brain and doingall sorts of crazy things. We're able to distillit down to simple lines and curves and equations. Now in the last video,we looked a little bit at the long run aggregate supply. Aggregate supply in the long run. In the ADAS model, weassumed that in the long run, the real productivityof the economy really doesn't depend on price,that price is really just a numeric thing and inthe long run, people will just adjust to producingor the economy will just adjust to producingwhat it's capable of comfortably producing. Now there's one thingI want to stress here. This is not the maximumproductivity of the economy. You could view this as the natural; let me put it this way. You could view this as the,so this right over here, you could view it as the natural output. Natural, the natural realoutput of the economy. When I say natural, it means that there's always going to be someinefficiencies in the economy; people are goingto be switching jobs. They might have to retrain. There's always going tobe turnover in things. Some people pass awayin a job and then they have to hire other people. There's some normal or natural rate of unemployment. In most economies, people aren't working night and day. They want to take some time off. They want to be able to rest. Because of otherinterventions, there aren't perfect efficiencies inthe economy as a whole. This is just a naturalhealthy level of output. There is some theoretical level of output. I'll draw that here. This is maybe sometheoretical level of output that you could maybeview as maximum output. Maybe I'll draw it right over here. This right over heremight be maximum output. Maximum, given the population and the technology that the population has, this is some type oftheoretical thing and it would be very hard to actually quantify. People were just working all out. They weren't taking vacations. They weren't sleeping properly. Every person was working in the place that they could be the mostproductive, then maybe you would have someoutput over here which is kind of impossible to achieve. This is something belowthat, kind of a nice healthy level of output for the economy. Now what we're going totalk about in this video is aggregate supply inthe short run and what we're going to see isfor this model to work, for the aggregatedemand-aggregate supply model to work, we have toassume an upward sloping aggregate supply curve in the short run. It might look something like this. It might look somethinglike this and obviously, it would; actually let me do it this way. Let's assume that thisis our current level of prices are sitting right over here. This is our long run aggregate supply. It's not depending onprices; it's just a natural level of output, but inthe short run it might look something like this. I'll do it in pink. In the short run, it mightlook something like this. As I'm toting it upbecause obviously we can never get past thatoptimal, so what's going on here, what's going on in this curve - I drew a dotted line becauseit's easier for me to draw something as adotted line when I draw it as a straight curve.My hand always shakes too much - so this is theaggregate supply in the short run. We'll see we need it tobe upward sloping for this model to providea basis of explanation for economic cyclesand there's a couple of explanations or a coupleof, you could really view them as theories,for why we can justify an upward sloping aggregate supply curve. The one way to thinkabout it and before I even justify why it could beupward sloping, what an upward sloping curve issaying is look, this is just when people are nicely... They're producing at their natural rate. There's going to besome unemployment in the economy at this level right over here. For whatever reason, thisupward curve is saying if prices go up, if prices go up, then the economy as a whole isgoing to produce beyond that natural rate. Maybe it's going to bringin people from other parts or I guess youcould say it's going to suck people in to thelabor pool who might not have been in the laborpool to work a little bit harder. Maybe they feel they cando a little bit better now. It might convince factoriesto run a little bit longer. It might convince peopleto take fewer vacations. The opposite might betrue if prices go down. An upward sloping curveis saying that if prices, aggregate prices - Nowthis isn't just prices in one good or service- if aggregate price is going down, it's sayingin the economy as a whole people might be incentedto work a little bit less. People might drop out of the labor pool. In the short run, rememberthis is all in the short run, they might dropout of the labor pool. They might not runtheir factories all out. They might take morevacations, whatever else. Now let's think about what our plausible justifications for anupward sloping aggregate supply curve. The first one is oftencalled the misperception theory; let me write it in white. It's the misperceptiontheory and it kind of makes sense to me that if theaggregate; let's think about a situation wherethe aggregate prices are going up. Aggregate prices are going up. If I'm an individualactor there, maybe I run a firm of some kind, Imight not notice immediately that it's aggregateprices that are going up. I might just think thatprices for my goods or services are going up. I might think that it's actually a micro economic phenomenon going on. I'm misperceiving itas a micro phenomenon. That's something that'sgoing on in my market. If I think and this goesback to the micro economics, if I think that prices formy goods and services are going up relative to others and remember this is a misperception, all prices are going up,but if I think this is happening in the short run then the law of supply kicks in. Then the law of supply kicks in which is a micro economic concept that if I feel that real prices - And it'snot real prices. It's actually nominal prices- but if I think my relative prices areincreasing, I'm motivated to produce more. I think I'm going to be more profitable. It only takes a littlebit of time for me to realize that all my costs are going up, what I can purchasewith my profits are all going up. In real terms, I'm actuallynot getting any better and then I'll probablysettle in back to my regular level of productivity. While I think people aredemanding more of Sal's sprockets or whateverI'm seeing, I'll start working over time. I might want to hire morepeople, run the factories beyond even a level thatI might defer maintenance so that I can run thefactories longer and all the rest, but then overtime I'm going to realize that I was just misperceiving things. Everything has gotten more expensive. I'm not making in realterms an outsized profit right now. Then my level of productivitymight actually go back. When I talk about me,it's not me by myself that's moving this whole economy. Remember I'm just talkingabout one actor, but this might be true of many,many, many actors in acting in aggregate soas a whole, they might want to increase productivityand then when they realize that in realterms they're actually not making any more money and that this isn't sustainable, they'll goback to their natural level of output. The other theory that you'll read about in economic textbooks, anothertheory or explanation or justification whywe would have an upward sloping aggregate supplycurve in the short run is sometimes it's calledthe sticky wages theory. Sticky wages. I like to extend it to sticky cost theory. Sometimes they'llarticulate a separate one called sticky prices,but in my mind these are all very similar, so stickywages, sticky costs and sticky prices. Sticky, sticky prices. It's the general ideathat even if in aggregate prices are increasing,so in the whole economy prices are increasing, inall parts of the economy they all won't increase at the same rate. There are parts of the economy where the prices mightbe stickier than other places and there's multiple reasons why prices could be sticky. You could have wagecontracts or people might just be slow to realizeprices are going up and then renegotiating their contracts. You might have long termagreements with suppliers that you're going topay a fixed price over some period of time. You've already agreed for the next year to pay it so even if aggregate prices are going up, it'sgoing to take a while in different parts of theeconomy, for contracts or for transactions inthose parts of the economy, to actually reflect those things. Another reason why inparts of the economy you might not have everythingmove in tandem or everything move as quicklyas you would expect is because of something called menu costs. Menu costs. Menu costs are just theidea that if prices are changing, if prices moveup in the next hour 5%, it's not actually trivial to increase your prices by 5%. For example, if you wererunning a restaurant, you would have to reprintnew menus, so that's where the name comes from,but it's not just true of a restaurant; it's true of anything. It would be true if you'reany type of supplier. You would have to change your brochures. You might have to changeyour computer systems. You have to do a ton ofthings to actually make things; you have to tell your sales force how the pricing might be different. There's a ton of thingsthat you have to do to actually change costs. These menu costs actuallymight slow down the ability for all prices to move in tandem. Some of them will bestickier than others and the reason why this is can be a rationale for an upward slopingaggregate supply curve in the short run is if I'm in one of these industries, let's saymy sales I am able to raise the prices butlet's say the wages and my costs are sticky. I've already got into along term wage contract and all my supplierscan't raise their prices as fast, so in the shortrun I'm going to say gee, I'm making a lot of profit now. Even in real termsbecause my costs are being relatively sticky, whilethe money that's coming in the door I'm ableto raise the prices so I'm going to produce more. I'm going to run the factories longer. Maybe I'll defer maintenance so that I can produce more. Maybe I'll try to hiremore people under these agreements. Maybe I'll try to buymore goods and services under these long term costs. The reason why I saythese are really the same side of the same coinis you can imagine here you have company A thatis able to increase its prices so its revenuestarts going up and let's say its supplier is company B. It's company B and thisright over here is sticky. This is sticky. Maybe A buys lemons from B and then sells lemonade. It's able to raise the price of lemonade, but it has a fixed pricecontract on the lemons in the short run. Eventually that will expire,in the long run B will be able to renegotiate it upwards. A's costs are sticky, but this is B's prices are sticky. These are really the samething that one's costs are really the other's prices.
