8.2 The Supply Side of the Economy

Question 1

What does the term “Aggregate supply” refer to?

Answer 1

Aggregate supply refers to the total output of goods and services that firms would like to produce and sell.

Question 2

Definition of the Aggregate supply curve.

Answer 2

Aggregate supply (AS) curve

      A curve showing the relation between the price level and the quantity of aggregate output supplied, assuming constant factor prices and technology.

Question 3

How will changes in factor prices or technology change the AS curve?

Answer 3

Changes in factor prices or technology will result in a shift of the AS curve.

Question 4

What is the definition of unit costs?

Answer 4

Unit costs

      Cost per unit of output, equal to total cost divided by total output.

Question 5

Why is the AS curve positivly slopped?

Answer 5

This positive relationship between output and unit costs leads to the positive slope of the AS curve, as shown in Figure 8-4. Firms who are interested in increasing their profits (and avoiding losses) will not be prepared to produce and sell more output unless they are able to charge a higher price sufficient to cover their higher unit costs.

The behaviour of profit-seeking firms causes the price level and the supply of output to be positively related—the AS curve is positively sloped.

Question 6

At low levels of GDP the AS curve is relatively flat, but as GDP rises the AS curve gets progressively steeper. What explains this shape?

Answer 6

When output is low, firms typically have excess capacity—some plant and equipment are idle. In the presence of excess capacity, increases in output generate only small increases in unit costs. As a result, only a small increase in the price of their output may be needed to induce them to expand production. Indeed, if firms have enough excess capacity, they may be willing to sell more at their existing prices when the demand for their product increases. In this case, output is truly demand determined and the AS curve is horizontal up to the level at which costs begin to rise.

Question 7

What is the horizontal portion of the AS curve often called?

Answer 7

The horizontal portion of an AS curve is often called the Keynesian range of the curve after John Maynard Keynes (1883–1946), who developed his important theory of macroeconomics to explain the nature of equilibrium during times of depressed activity, high unemployment, and excess capacity among firms.

Question 8

What is the shape of the AS curve crucial for determining?

Answer 8

As we will see later in this chapter, the shape of the AS curve is crucial for determining how the effect of an aggregate demand shock is divided between a change in the price level and a change in real GDP.

Question 9

What happens to the AS curve when there is a change in factor prices or technology?

Answer 9

Recall that the AS curve is drawn for a given set of factor prices and a given state of technology. Anything that leads to a change in these variables will then cause a shift in the AS curve, indicating that firms require a different price level in order to provide the same level of output.

Question 10

Definition of an aggregate supply shock.

Answer 10

Aggregate supply shocks

      Any shift in the aggregate supply (AS) curve caused by an exogenous force.

Question 11

What are factor prices?

Answer 11

To produce goods and services, firms use factors of production as inputs, including various types of land, labour, and physical capital. The prices firms pay for these factors are called factor prices. When factor prices change, the AS curve shifts.

Question 12

What happens to a firms profits when factor prices rise?

Answer 12

If factor prices rise, firms’ profits at their current levels of output are reduced.

Question 13

How do firms respond to a rise in factor prices?

Answer 13

• Maintaining their current level of output, in which case they require an increase in the price level.
• Reducing their level of output if the price level does not change.

In either case, in response to a rise in factor prices, the AS curve shifts upward (and to the left). This is a decrease in aggregate supply

Question 14

What does a fall in factor prices do to the AS curve?

Answer 14

A fall in factor prices makes production more profitable and causes the AS curve to shift downward (and to the right). There will be more output supplied at each price level. This is an increase in aggregate supply.

Question 15

What happens to the AS curve when prices of Raw materials change?

Answer 15

Raw materials are important inputs to the production process, and changes in their prices also cause shifts in the AS curve.

For example, when the world price of oil fell sharply in the fall of 2014, the costs of production in many industries fell, shifting the AS curves downward in most countries.

The opposite happens when raw materials prices rise sharply, increasing firms’ costs and causing the AS curve to shift upward and to the left.

Question 16

In general terms, how do increases and decreases in factor prices and other inmput prices effect the AS curve?

Answer 16

Increases in factor prices and other input prices are negative aggregate supply shocks that cause the AS curve to shift upward and to the left. Decreases in factor prices and other input prices cause the AS curve to shift downward and to the right.

Question 17

For our purposes, how are we defining an “improvement in technology”?

Answer 17

For the purposes of our discussion, we define an improvement in technology as any change to production methods that reduces unit costs for any given level of output.

Question 18

How do improvements in technology affect the unit costs and the AS curve?

Answer 18

Improvements in technology reduce unit costs and typically lead to lower prices as competing firms cut prices in attempts to raise their market share. Since the same output can now be sold at lower prices, the AS curve shifts downward and to the right. This is an increase in aggregate supply.

Question 19

How do we define a “Deterioration in technology”?

Answer 19

A deterioration in technology is any change in production methods that raises unit costs for any given level of output. Since firms are unlikely to intentionally adopt new methods that raise their costs, the latter occurrences are rare. However, in industries that rely on specific weather conditions for production—like agriculture—poor weather can be interpreted as a deterioration in technology.

Question 20

How does a deterioration of technology effect unit cots and what does this do to the AS curve?

Answer 20

A deterioration in technology raises unit costs and causes the AS curve to shift upward and to the left

Question 21

In conclusion, how do improvements and deteriorations in technology affect the As curve?

Answer 21

A deterioration in technology increases firms’ costs and shifts the AS curve upward and to the left; an improvement in technology reduces firms’ costs and shifts the AS curve downward and to the right.

Question 22

What assumtion do we make about changes in factor prices and technology in this chapter?

Answer 22

For the remainder of this chapter, however, we retain the assumption that any changes in factor prices (or technology) are exogenous. Such aggregate supply shocks play an important role in explaining real-world changes in equilibrium GDP and the price level.

Question 23

What would a decrease in demand for Canada’s exports do to the AS curve?

Answer 23