Why Do Short-Run AS and Long-Run AS Differ?

Why does aggregate supply behave differently in the long. and short runs? Why.do firms raise both prices and output in the short run as aggregate demand increases? Why, by contrast, do increases in demand lead to price changes with little output change.in the
long run?

The key to these puzzles lies in the behavior of wages and prices in a modern market economy. Some elements of business costs are inflexible en. sticky in the short run. As a result of this inflexibility, businesses can profit from higher levels of aggregate demand by producing more output.

Suppose that concerns over national security lead to an increase in defense spending. Firms know that in the short run many of their production costs are in dollar workers are paid $15 per hour, rent-is $1500 per month, and so forth. In response ‘to the higher demand, firms will generally raise their output prices and increase production. This positive association between prices and output is seen in the upward-sloping AS curve in Figure 31-3(a).

What happens in the long run? Eventually, the .. inflex.ible or sticky elements of cost-wage contracts, rent agreements, regulated prices, and so forth-become unstuck and negotiable. Firms cannot take advantage of fixed-money wage rates in their labor agreements forever; labor will soon recognize that prices have risen and insist on compensating increases in wages. Ultimately, all costs ,will adjust LO the higher output prices. If the general price level rises by x percent because of the higher demand, then money wages, rents. regulated prices, and other costs will in the end respond by up around x percent as well.

The aggregate supply for an economy will differ from potential output in the short run because of inflexible elements of costs. In the short run, firms will re pond to higher demand by raising both production and prices. In the longer run, as costs respond to the higher level of prices, most or all of the reponse to increased demand takes the form of higher prices and little or none the form of higher output. Whereas the short-run AS curve is upward-sloping, the long-run AS curve is vertical because, given sufficient time, all costs adjust.

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