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Lesson M07.L04: Short-Run Aggregate Supply: Derivation and Shifts

Module: Aggregate Demand and Aggregate Supply; Macroeconomic Policy Level: intro Duration: 30 minutes Learning Objective: Derive the upward-sloping SRAS curve from sticky wages and prices. Data as of: 2023 Provenance: OpenStax Macro 3e | MIT OCW 14.02

Explanation

The Short-Run Aggregate Supply (SRAS) curve shows the total quantity of goods and services that producers in the economy are willing to supply at each overall price level, holding input costs (especially wages) fixed. It slopes upward: as the price level rises, firms produce more.

Why? Sticky wages and prices.

In the short run, wages are "sticky" — they do not adjust immediately to changes in economic conditions. Workers typically have employment contracts, enterprise bargaining agreements, or simply resist nominal wage cuts. In Australia, the Fair Work Commission sets minimum wages annually, but most adjustments lag market conditions.

Here is the logic: 1. Firms set wages in advance (e.g., under an enterprise agreement). 2. If the overall price level rises, the prices firms receive for their goods rise, but wages stay the same. 3. This means the real wage (purchasing power of wages) falls for workers temporarily. 4. Lower real labour costs make it profitable for firms to hire more workers and increase output. 5. Therefore, higher price level → more output supplied → SRAS slopes upward.

Factors that shift SRAS:

  • Input costs change: A rise in oil prices raises costs for most industries → SRAS shifts left (less supplied at every price). A fall in raw material costs shifts SRAS right.
  • Wages change: A rise in the minimum wage increases costs → SRAS shifts left.
  • Technology improves: More efficient production reduces costs per unit → SRAS shifts right.
  • Import prices: Australia imports many manufactured goods; a higher AUD (cheaper imports) lowers production costs → SRAS shifts right.
  • Supply chain disruptions: As seen in 2021–22, global shipping delays raised costs → SRAS shifted left.

Worked Example

Suppose Australian firms collectively pay an average wage of $80,000 per worker per year, locked in by enterprise agreements for two years.

Initial situation: Price level = 100. Firms receive $60 per unit produced.
Real unit labour cost = Wage / Price level = \(80,000 / 100 = **\)800 per index unit**

Firms find it just profitable to hire 12 million workers → GDP = $2,000 billion.

Price level rises to 110: Wages remain $80,000 (sticky).
Firms now receive $66 per unit (= $60 × 110/100).
Real unit labour cost = \(80,000 / 110 = **\)727 per index unit** (a fall of ~9%)

Step 1: Nominal wages unchanged: $80,000
Step 2: New real cost = \(80,000 ÷ 110 × 100 = **\)72,727 (in base-year dollars)
Step 3: Old real cost = \(80,000 ÷ 100 × 100 = **\)80,000
Step 4: Real labour cost has fallen by: $80,000 − \(72,727 = **\)7,273** per worker

This makes hiring more profitable. Firms expand employment and output.
New GDP ≈ $2,080 billion → output rises as price level rises → SRAS slopes upward.

Common Misconception

Misconception: The SRAS curve slopes upward for the same reason as a firm's supply curve — because higher prices make production more profitable at the margin.

Correction: While that intuition captures part of the story, the macro explanation is specifically about sticky wages. The SRAS curve is upward-sloping because wages (the largest input cost) are fixed in the short run. When the price level rises but wages don't, real labour costs fall and firms expand output. If wages adjusted instantly, the supply curve would be vertical (as with LRAS). The stickiness of wages is the key mechanism.

Practice Prompts

  1. If global oil prices spike (e.g., due to conflict in the Middle East), what happens to Australia's SRAS and why? → Answer: Oil is a major input cost across transport, manufacturing, and agriculture. Higher oil prices raise costs for Australian firms → SRAS shifts left → less output supplied at every price level, contributing to higher inflation and lower GDP (stagflation risk).

  2. The Fair Work Commission grants a 5.75% increase in the national minimum wage (as occurred in 2023). How does this affect the SRAS curve? → Answer: Higher minimum wages raise labour costs for firms. SRAS shifts left — firms supply less at every price level, putting upward pressure on prices and downward pressure on output in the short run.

  3. What is the key assumption that makes the SRAS curve slope upward rather than being vertical? → Answer: The key assumption is that nominal wages (and some other input prices) are sticky — they do not immediately adjust to changes in the overall price level. If wages adjusted instantly, there would be no change in real labour costs and no incentive to change output, making supply vertical.

Visual — Short-Run Aggregate Supply and a Cost Shock

Upward-sloping SRAS Real GDP Price level SRAS Sticky wages mean firms expand output as P rises. Input-cost shock shifts SRAS left Real GDP Price level SRAS₀ SRAS₁ Oil-price spike or wage shock raises costs, so firms supply less at every price level.

Figure: The short-run aggregate supply curve slopes upward because sticky input costs make higher output profitable when prices rise. Higher input costs shift SRAS leftward.

Further Resources