Short run aggregate supply | Aggregate demand and aggregate supply | Macroeconomics | Khan Academy

In the last two videos, we've been slowly

building up our aggregate demand-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 cycles and we don't just have

this nice steady march of economic growth due to

population increases and productivity improvement.

It's important to realize and it's probably

important to realize this for all of what we study

in micro and macro economics that this is really

just a model.

In order for to use these models, we have to

make huge, huge simplifications 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's an over simplification.

You might want to modify it in some way.

It's very important that you just view it only

as a model and the reason why we do that is so

that we can start to describe very, very, very

complicated things with fairly simple graphs

and mathematics so that we can get our brain

around something as complicated as the economy.

Something that has hundreds of millions of actors,

each of them with tens of billions of neurons

in their brain and doing all sorts of crazy things.

We're able to distill it 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, we assumed that in the long run,

the real productivity of the economy really

doesn't depend on price, that price is really just

a numeric thing and in the long run, people will

just adjust to producing or the economy will

just adjust to producing what it's capable of

comfortably producing.

Now there's one thing I want to stress here.

This is not the maximum productivity 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 real output of the economy.

When I say natural, it means that there's

always going to be some inefficiencies in the

economy; people are going to be switching jobs.

They might have to retrain.

There's always going to be turnover in things.

Some people pass away in a job and then they

have to hire other people.

There's some normal or natural rate of


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 other interventions, there aren't

perfect efficiencies in the economy as a whole.

This is just a natural healthy level of output.

There is some theoretical level of output.

I'll draw that here.

This is maybe some theoretical level of output

that you could maybe view as maximum output.

Maybe I'll draw it right over here.

This right over here might be maximum output.

Maximum, given the population and the

technology that the population has,

this is some type of theoretical 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 most productive, then maybe

you would have some output over here which is

kind of impossible to achieve.

This is something below that, kind of a nice

healthy level of output for the economy.

Now what we're going to talk about in this video

is aggregate supply in the short run and what

we're going to see is for this model to work,

for the aggregate demand-aggregate supply model

to work, we have to assume an upward sloping

aggregate supply curve in the short run.

It might look something like this.

It might look something like this and obviously,

it would; actually let me do it this way.

Let's assume that this is our current level of

prices are sitting right over here.

This is our long run aggregate supply.

It's not depending on prices; it's just a natural

level of output, but in the short run it might

look something like this.

I'll do it in pink.

In the short run, it might look something like this.

As I'm toting it up because obviously we can

never get past that optimal, so what's going on

here, what's going on in this curve -

I drew a dotted line because it's easier for me to

draw something as a dotted line when I draw

it as a straight curve. My hand always shakes too

much - so this is the aggregate supply in the

short run.

We'll see we need it to be upward sloping for

this model to provide a basis of explanation

for economic cycles and there's a couple of

explanations or a couple of, you could really

view them as theories, for why we can justify

an upward sloping aggregate supply curve.

The one way to think about it and before I even

justify why it could be upward sloping, what an

upward sloping curve is saying is look, this is

just when people are nicely ... They're producing

at their natural rate.

There's going to be some unemployment in the

economy at this level right over here.

For whatever reason, this upward curve is saying

if prices go up, if prices go up, then the

economy as a whole is going to produce beyond

that natural rate.

Maybe it's going to bring in people from other

parts or I guess you could say it's going to

suck people in to the labor pool who might not

have been in the labor pool to work a little

bit harder.

Maybe they feel they can do a little bit better now.

It might convince factories to run a little bit


It might convince people to take fewer vacations.

The opposite might be true if prices go down.

An upward sloping curve is saying that if prices,

aggregate prices - Now this isn't just prices

in one good or service - if aggregate price is

going down, it's saying in the economy as a whole

people might be incented to work a little bit less.

People might drop out of the labor pool.

In the short run, remember this is all in the

short run, they might drop out of the labor pool.

They might not run their factories all out.

They might take more vacations, whatever else.

Now let's think about what our plausible

justifications for an upward sloping aggregate

supply curve.

The first one is often called the misperception

theory; let me write it in white.

It's the misperception theory and it kind of makes

sense to me that if the aggregate; let's think

about a situation where the aggregate prices are

going up.

Aggregate prices are going up.

If I'm an individual actor there, maybe I run

a firm of some kind, I might not notice immediately

that it's aggregate prices that are going up.

I might just think that prices for my goods or

services are going up.

I might think that it's actually a micro

economic phenomenon going on.

I'm misperceiving it as a micro phenomenon.

That's something that's going on in my market.

If I think and this goes back to the micro economics,

if I think that prices for my 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's not real prices. It's

actually nominal prices - but if I think my

relative prices are increasing, I'm motivated

to produce more.

I think I'm going to be more profitable.

It only takes a little bit of time for me to

realize that all my costs are going up,

what I can purchase with my profits are all

going up.

In real terms, I'm actually not getting any better

and then I'll probably settle in back to my

regular level of productivity.

While I think people are demanding more of Sal's

sprockets or whatever I'm seeing, I'll start

working over time.

I might want to hire more people, run the factories

beyond even a level that I might defer maintenance

so that I can run the factories longer and all

the rest, but then over time I'm going to realize

that I was just misperceiving things.

Everything has gotten more expensive.

I'm not making in real terms an outsized profit

right now.

Then my level of productivity might actually go back.

When I talk about me, it's not me by myself

that's moving this whole economy.

Remember I'm just talking about one actor, but this

might be true of many, many, many actors in

acting in aggregate so as a whole, they might

want to increase productivity and then when they

realize that in real terms they're actually not

making any more money and that this isn't

sustainable, they'll go back to their natural

level of output.

The other theory that you'll read about in

economic textbooks, another theory or explanation

or justification why we would have an upward

sloping aggregate supply curve in the short run

is sometimes it's called the sticky wages theory.

Sticky wages.

I like to extend it to sticky cost theory.

Sometimes they'll articulate a separate one

called sticky prices, but in my mind these are

all very similar, so sticky wages, sticky costs and

sticky prices.

Sticky, sticky prices.

It's the general idea that even if in aggregate

prices are increasing, so in the whole economy

prices are increasing, in all parts of the economy

they all won't increase at the same rate.

There are parts of the economy

where the prices might be stickier than other

places and there's multiple reasons why

prices could be sticky.

You could have wage contracts or people might

just be slow to realize prices are going up

and then renegotiating their contracts.

You might have long term agreements with suppliers

that you're going to pay 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's going to take a while in

different parts of the economy, for contracts

or for transactions in those parts of the economy,

to actually reflect those things.

Another reason why in parts of the economy you

might not have everything move in tandem or

everything move as quickly as you would expect

is because of something called menu costs.

Menu costs.

Menu costs are just the idea that if prices are

changing, if prices move up in the next hour 5%,

it's not actually trivial to increase your

prices by 5%.

For example, if you were running a restaurant,

you would have to reprint new 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're any type of supplier.

You would have to change your brochures.

You might have to change your computer systems.

You have to do a ton of things to actually make

things; you have to tell your sales force

how the pricing might be different.

There's a ton of things that you have to do to

actually change costs.

These menu costs actually might slow down the

ability for all prices to move in tandem.

Some of them will be stickier than others and

the reason why this is can be a rationale

for an upward sloping aggregate supply curve

in the short run is if I'm in one of these

industries, let's say my sales I am able to

raise the prices but let's say the wages and my

costs are sticky.

I've already got into a long term wage contract

and all my suppliers can't raise their prices

as fast, so in the short run I'm going to say gee,

I'm making a lot of profit now.

Even in real terms because my costs are being

relatively sticky, while the money that's coming

in the door I'm able to 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 hire more people under these


Maybe I'll try to buy more goods and services

under these long term costs.

The reason why I say these are really the same

side of the same coin is you can imagine here

you have company A that is able to increase

its prices so its revenue starts going up and

let's say its supplier is company B.

It's company B and this right over here is sticky.

This is sticky.

Maybe A buys lemons from B and then sells


It's able to raise the price of lemonade,

but it has a fixed price contract 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 same thing that one's costs

are really the other's prices.