Prices are based on market expectations in the short

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Prices are based on market expectations in the short term. Suppliers of inputs and producers of outputs estimate their supply of / demand for inputs in the coming year on expected output price levels. If the actual price level > expected price level, inputs are cheaper than expected and sold at bargain prices and total product increases. If the actual price level < expected price level, inputs are more expensive than expected and therefore production decreases. o An unanticipated increase in the price level therefore causes an increase in aggregate production / supply o POSITIVE relationship between the price level and aggregate supply in the short term. 2. Declining productivity of inputs Production will only increase in response to an increase in expenditure (demand) if the price level increases o If producers attempt to increase production they are forced to employ more inputs =>
o Due to declining marginal productivity of inputs each additional input will contribute less to total production. o This means an increase in average cost of production o Producers will only increase production if they are compensated for higher production cost by higher output prices. o POSITIVE relationship between the price level and aggregate supply 3. Relative scarcity of inputs As production increases, inputs become relatively scarcer. Increasing competition for inputs will put pressure on input prices. Producers will only produce more if they are compensated for higher input costs via higher output prices. POSITIVE relationship between the price level and aggregate supply. Short run AS curve Positive relationship between prices and aggregate production in the short run. Increase in output caused ->>increase P above long run and increase output to new profit opportunities - drop in P ->> drop in Output. Shape of the AS SR curve: If the economy is operating far below maximum capacity (saturated market employment where producers have absorbed inputs to the maximum extent possible, Y MAX ) => inputs are eager to be employed and there is only a small increase in input prices when producers attempt to increase production. (will only produce more if price per unit increases.) AS is flatter (more horizontal) If the economy is closer to maximum capacity => inputs are scarce and high input price increases are necessary to increase production. AS is steep (more vertical) If the economy is past maximum capacity => no increase in production is possible no matter what the increase in prices are = vertical Area on short run supply curve when it becomes very steep- before reaching virtical point -> called bottleneck erea Reflects increasing difficulty of trying to increase output by adding additional labour to production process that operates with fixed amount of capital in short run.

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