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9
Introduction to
Aggregate Supply
Chapter Overview
In Chapter 8, we reinterpreted the theory of nominal effective demand developed in Chapter 7 in real terms. Our
theory of expenditure and income determination linked aggregate spending to the generation of income. This
focus on the demand drivers of aggregate income and output abstracted from any spending impacts on the price
level and assumed that the multitude of firms in the economy were rather passive. They simply responded to
growth in nominal spending by increasing real output up to the full capacity level in the economy.
In Chapter 7, however, we noted that the point of nominal effective demand is in fact found at the intersection of
the aggregate demand (D) and aggregate supply price (Z) curves. We learned that the point of effective demand
occurs where all individual firms are maximising expected profits.
In this Chapter we consider the Z function that Keynes proposed (using what is known as the Marshallian
supply price), which abstracts from notions of industrial concentration (or degree of monopoly). The degree of
monopoly influences the capacity of the firms to set rather than take prices.
Further, the Z function relates total revenue (income) in nominal terms to employment. As we learned in
Chapter 8, this was a reasonable path for Keynes to take because the advances in national accounting were
minimal at the time he was forming his ideas and made it difficult to formulate a reliable measure of real output
(income). Total employment was a more reliable measure of (real) quantity.
However, national income accounting is now very sophisticated and great advances were made in the 1950s and
beyond which allow for more reliable measures of real (constant price) output. In that context, economists
started to move away from the nominal DZ framework and instead sought to relate real output directly to a
measure of the aggregate price level. In this context, an aggregate supply function describes the real output
(goods and services) that the firms in aggregate will be prepared to supply at each price level.
The price-quantity (real) version (Chapter 8 ) of the nominal DZ framework (Chapter 7) was developed to help
us focus on the demand-side of the economy. In doing so, we ignored the complexity of the supply-side. For
example, we abstracted from what might happen after the economy reached its full capacity level.
So we are, as yet, not equipped with a framework that allows us to articulate how the economy responds to a rise
in nominal aggregate demand (spending).
When nominal aggregate spending rises the economy can respond in the following ways:
1.
Increase real output (this is what we assumed in Chapter 8).
2.
Increase prices.
3.
A combination of increasing real output and increasing prices.
In this Chapter we seek to develop an understanding of when each of these options might arise in a modern
monetary economy and what might be considered to be the usual case. This is an important issue because it
influences the way we construct macroeconomic policy in relation to maintaining the goals outlined in Chapter
1 – full employment, price stability and equity.
The first option – increase real output – is sometimes referred to as quantity adjustment while the second
option – increase prices – is referred to, in the same nomenclature to be price adjustment. In this Chapter we
aim to consider the conditions under which a macroeconomy might be considered to be a quantity adjusting
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economy as opposed to the conditions that would lead us to conclude the economy is a price adjusting one.
The theory we develop in this chapter will therefore complete the demand-side model that we developed in
Chapter 8 to allow us to determine the real output level, the price level and total employment.
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Some notes on Aggregate Supply Posted on Friday, July 6, 2012 by bill
[NOTE: All graphs etc will be professionally drawn rather than plotted using a spreadsheet as below.]
[MORE INTRODUCTORY MATERIAL HERE ON CONCENTRATION, INDUSTRY STRUCTURE ETC ....
]
9.1
Some Introductory Concepts
The concept of schedules and functions
In Chapter 4 Methods, Tools and Techniques we introduced the essential analytical and introductory techniques
that students should learn in order to grasp macroeconomics.
As a reminder, economic models use schedules or curves to depict behaviour, which can either be ex ante (prior
to action and reflects planned or desired action by households, firms, government etc); or ex post, which
represents actual outcomes that are the result of action.
In the most simple macroeconomic model of expenditure, income and employment we encounter an aggregate
demand schedule and an aggregate supply schedule. These schedules depict ex ante behaviour and tell us what
the outcomes will be given other conditions in the economy. In this Chapter we will consider aggregate supply
schedules.
The terms – schedule and function – are used interchangeably in the economics literature. We prefer to use
function to depict a relationship between variables of interest – such as spending and income.
The employment-output function
To develop a theory of employment – that is, explain its level and movement over time – in relation to a
monetary economy operating under capitalist conditions, we need to develop an understanding of how
employment is related to output determination. We focus on that question in more detail in Chapters 10 and 11
but for now we need to consider this relationship because it impacts on cost movements in the economy. In this
context we develop the concept of the Employment-Output function, which shows the how much labour is
required to produce a given volume of real output.
Assume that the amount of labour that a firm hires is determined by the amount of output that they plan to
produce. This decision is made in an environment of stable wage rates and capital-labour ratios. The capitallabour ratio depicts the combination of productive capital (machines, equipment, etc) and labour that defines the
current productive technology.
For example, an excavation firm might provide a hand shovel to each worker engaged in digging foundations
for a new building. This would be a low capital-labour ratio production technology. Sometimes this is referred
to as a labour-intensive technique.
Alternatively, it could use mechanical digging equipment and employ less workers to produce the same output.
In this instance, the production process would employ higher capital-labour ratio techniques – sometimes
referred to as capital-intensive production.
We can write the employment-output function as:
(9.1)
Y = αN
where N is the total number of workers employment, α is the rate of labour productivity, and Y is planned
output (based on expected spending), which is equal to the actual income generated in the current period. Firms
produce based on expected aggregate spending and once all the sectors have made their spending decisions (that
is, once aggregate demand is actually realised), the firms discover whether their expectations were accurate or
not. That is, they discover whether they have overproduced, under-produced or produced according to the
spending actions realised.
What is labour productivity? Labour productivity is defined as output per unit of labour input. So we could solve
Equation 9.1 for α to get Y/N, which is the algebraic equivalent of our definition.
The higher is labour productivity (α) the less employment is required to produce a unit of output for a given
production technique (implicit in α).
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Factors which influence the magnitude of α include: technology (whether it is best-practice, capital- or labourintensive); worker skill and motivation; and management skill and business organisation. Often in the public
discussions about slowing productivity growth there is an undue focus on the worker with claims such as poor
motivation and skill gaps. Rarely is management skill the focus of enquiry despite evidence that poor
management decision-making is a cause of slow productivity growth. For example, failure to invest in the latest
technology.
As an example, the Australian airline Qantas dominated the international travel market for Australians travelling
abroad. In the late 1970s the airline carried around 42 per cent of Australian travellers abroad. By 2012, this
proportion had dropped to 18 per cent as competition from airlines such as Emirates and Singapore Airlines has
cut into its market share. There are many reasons for this decline in market share, but one of the major
explanations is that Qantas management made poor decisions with respect to its fleet upgrades and refused to
invest in the latest jets which are more fuel efficient and hence can operate at lower costs.
If α is stable in the short-run (within the current investment cycle) then once the firm decides on the level of
output to produce, to satisfy expected demand, it simultaneously knows how many workers must be employed.
Figure 9.1 shows the two different employment-output functions, both are proportional (that is, straight lines)
but positively sloped (according to the size of α).
If the firms expected demand for its output would be $1200 million in the current production period, then given
the state of technology (represented by α) it would employ 600 workers if α = 2 (lower productivity) and 400
workers if α = 3 (high productivity).
Figure 9.1
The Employment-Output function
1600
Output Y ($ millions)
1400
1200
1000
800
600
400
200
0
0
100
200
300
400
500
Employment (000s)
alpha α 2
600
700
800
Alpha α 3
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Money wages
In Chapter 10 we will consider wage determination in detail. For now we use some simple, but realistic
assumptions to motivate the analysis in this Chapter.
A useful short-run assumption therefore is to assume that money wage rates are exogenous in the short-run. This
is not the same as assuming that money wage rates never change. It merely says that, in terms of the parameters
of our aggregate supply model (that is, the different influences we will consider that impact on aggregate
supply), the money wage rate will be assumed to be invariant in the short-run.
Before we discuss the possible factors which make this a reasonable assumption to make, we must first clarify
some, often-confused concepts relating to wages.
We distinguish between the money wage rate and the real wage rate.
The money wage rate is determined in the labour market and is the amount, in nominal (current dollar) terms,
that the workers receive per hour when they sell their labour power to the capitalist business firms or other
employers (for example, government). The actual money wage at any point in time is the outcome of
agreements reached between employers and workers, either on a decentralised negotiated basis or through
sector- or economy-wide negotiations. In some nations, such as Australia, there has been a history of wage
setting tribunals (courts) which place the determination of wages into the judicial jurisdiction, reflecting the
adversarial nature of relations between workers and capital.
The wage outcome at any point in time is heavily dependent on the bargaining strengths of the parties involved.
Wage changes occur at infrequent intervals and condition the behaviour of the parties concerned for the ensuing
economic period (sometimes months, usually years). It is this infrequent nature of wage setting via institutional
structures (such as, employer-union negotiations) and the implied contractual nature of the wage relationship
existing between employers and workers over some future period, which is used to justify the assumption that
wages are exogenous in the short-run for the purpose of developing an explanation of aggregate supply.
The real wage rate is the money wage rate deflated by some price index. We learned how deflators are
constructed and are used to convert current price variables into constant price (real) variables in Chapter 4
Methods, Tools and Techniques.
The choice of deflator depends on the context. The real wage, may from the perspective of the worker, be the
money wage expressed in terms of real consumption good equivalents. So we would consider this rate to be the
money wage rate divided by the measure of consumer prices (the CPI).
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From the employer’s perspective, the real (product) wage is more accurately measured by the money wage paid
to workers divided by the specific price the firm receives for its output, which is a more narrow concept than the
real wage considered from the perspective of the worker.
Importantly, contrary to what most mainstream textbooks will suggest, the real wage is not determined in the
labour market and can only be influenced by the workers in as much as they can influence the money wage rate
outcome.
The real wage is a ratio of two prices – the money wage (determined in the labour market) and the consumer
price level (determined in the goods and services market). The two prices which form the real wage rate are
determined by different forces in different markets in the economy.
As we will see, prices are assumed to be set by business firms in the goods and services (product) market
according to desired mark-ups on cost. Prices are not fixed by workers.
Often economists and others suggest that workers should cut their real wages to improve the employment
prospects of the unemployed. We will examine the logic of this proposition in detail in Chapters 10 and 11 and
conclude that the policy suggestion is without merit. But as a precursor to that discussion, even if the
proposition was based on a causal understanding of how mass unemployment occurs, there are several
preliminary, but critical questions that such proposals fail to answer.
How can workers achieve a cut in their real wage when all they can do is influence the money wage outcome?
How might a money wage change influence price changes?
Might a money wage cut also provoke price cuts as costs of production fall, and thus leave the real wage
unchanged?
These initial queries are quite apart from the dispute among economists as to whether a real wage cut would
influence employment growth independent of changes in effective demand. That question is addressed in later
chapters.
What is the basis of the money wage inflexibility assumption? There is strong evidence that workers resist cuts
in money wages and firms, generally prefer not to offer such cuts. Only in extraordinary circumstances relating
to the imminent collapse of the enterprise in they are employed and the existence of very high levels of
unemployment have we observed workers agreeing to money wage reductions.
The downward rigidity of money wages is also the result of employer preferences. Even when the
unemployment rate approaches double figures (a rate considered high by historical standards), the absolute
number of workers not in employment relative to those who retain their jobs is small. As such, employers are
reluctant to risk jeopardising convivial industrial relations with this large number of workers to improve the
fortunes of a small proportion of the labour force.
We consider these issues in more detail in Chapter 11 Unemployment and Inflation and Chapter 17 Keynes and
the Classics.
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9.2
Keynes’ Aggregate Supply Price (Z) Function
Before we consider the way in which the economy prorate nominal aggregate demand between real output and
prices we consider the aggregate supply price model that Keynes developed in his General Theory, which
complements the effective demand analysis that was presented in Chapter 7 Introduction to Effective Demand –
Nominal D-Z analysis.
The goods and services market of the economy is where output is produced and sold. Sometimes this is referred
to as the product market. In Chapter 5 The National Accounting (NIPA) Framework, we studied the way the
national statistician measures the aggregate activity that occurs in the goods and services market. We saw that
total nominal (current price) output (or GDP) can be expressed simply as PY, where P is the aggregate price
level and Y is total real output.
So the total market value of output produced in the economy in any period is expressed as the total real output
produced valued by the aggregate price level.
This is our starting point. Later in the Chapter we will separate out the two components – price and quantity – to
develop an understanding of the questions posed at the outset of this chapter – how does the economy respond to
a rise in nominal aggregate demand in terms of output and prices.
But first we consider how Keynes considered the relationship between total revenue (income) – PY – and
employment.
Chapter 3 of the General Theory is entitled “The Theory of Effective Demand” and the discussion that follows
provided the basis for the basic macroeconomics of output and income determination that you will find in most
textbooks.
Keynes said that when a business firm hires labour they will incur “two kinds of expense”. These labour costs
are:

The factor cost – the amounts the firm has to pay the workers; and

The user cost – the amounts the firm has to pay other firms for capital inputs.
The amount that the firm receives by selling the resulting output over the sum of these costs is their income or
profit. The factor cost is the income of the workers. So, total income is the sum of profits and factor costs.
Keynes argued that the motivation of the business firm when employing workers is to maximise the profit it
receives from the output they produce. In that context, we might consider aggregate or total income which is
derived from each level of employment to be the “proceeds of that employment”.
From another perspective, Keynes said that:
… the aggregate supply price of the output of a given amount of employment is the expectation of
proceeds which will just make it worth the while of the entrepreneurs to give that employment.
This idea provides the basis for his aggregate supply price function which indicates, for all the possible
employment levels, how much revenue (income) the firms would require to render each employment level
consistent with profit maximisation.
Clearly, we could vary the profit maximisation objective to incorporate different aims regarding margins. But
that complexity is not germane at this point.
In constructing the aggregate supply price function, Keynes assumed that production techniques, resource
availability and the money wage rate were given. Under these conditions, firms thus
… endeavour to fix the amount of employment at the level which they expect to maximise the
excess of the proceeds over the factor cost.
Accordingly, Keynes defined his Aggregate Supply Function, Z to be the “aggregate supply price of the output
from employing N men” and the schedule was written as Z = φ(N).
As a practical example, consider the data in Table 9.1 which describes the derivation of an Aggregate Supply
function under two assumptions about money wage rates.
Columns (2) to (4) assume a constant money wage rate of $15 per hour and that there are 52 working weeks in
the year. Each working week is 35 hours so that a full-time worker is engaged for 1820 hours per year in
employment. Firms, in turn, require a 20 per cent profit return on total costs (which in this example are total
labour costs). So when money wages are fixed at $15 per hour, firms require a profit mark-up of $3 per hour.
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By way of interpretation, for the economy to employ 11 million workers, the business firms in total would
require $360 million in total revenue per year to cover their total labour costs ($15 per hour times 35 hours per
week times 52 weeks in the year) plus their desired profit mark-up on per hourly wage.
Table 9.1
Aggregate Supply Functions, fixed and increasing money wage rates
Fixed Money Wage Rate
Employment
(N)
Money wage
rate
Profit
Mark-up
000’s
$ per hour
$ per hour
10.0
15.00
10.2
Increasing Money Wage Rate
Aggregate
Supply Price
Aggregate
Supply Price
Money wage
rate
Profit
Mark-up
$ millions
$ per hour
$ per hour
$ millions
3.00
328
15.00
3.00
328
15.00
3.00
334
15.00
3.00
334
10.4
15.00
3.00
341
15.00
3.00
341
10.6
15.00
3.00
347
15.00
3.00
347
10.8
15.00
3.00
354
15.00
3.00
354
11.0
15.00
3.00
360
15.00
3.00
360
11.2
15.00
3.00
367
15.30
3.06
374
11.4
15.00
3.00
373
15.60
3.12
388
11.6
15.00
3.00
380
15.90
3.18
403
11.8
15.00
3.00
387
16.20
3.24
417
12.0
15.00
3.00
328
15.00
3.00
432
(Z)
(Z)
Figure 9.2 captures this data in graphical form with the solid line depicting the fixed money wage rate
assumption. Under this assumption, the slope of the Z-function is upward sloping because when money wage
rates are fixed, the total costs of employment rise as more workers are hired. Firms will thus require more sales
revenue (proceeds or total income) at each level of employment to ensure they can cover their costs of
production and generate the desired profit income.
The schedule might also slope upwards (even more steeply than the fixed money wage rate schedule depicted in
Figure 9.2) if firms have to pay higher wages as employment rises and unemployment falls. The data depicted in
Columns (5) to (8) of Table 9.1 reflects this possibility with full employment assumed to be 11.8 million. We
assume that after employment reaches 11 million, firms pay higher hourly money wage rates as shown in Table
9.1, which has the effect of increasing total labour costs.
In this case, the Z-function would become steeper – see the dotted line in Figure 9.2.
The faster the money wage rate rises as the economy approaches full employment, the steeper would the Zfunction become and the less responsive total employment would become to a given change in expected total
income. Once the economy reaches full employment the Z-function would become vertical because no further
employment could be offered.
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Figure 9.2
Aggregate Supply Function (Z) under different money wage rate assumptions
Expected total income Z ($ millions)
440
Full Employment
420
Z Function - increasing money wage rate
400
Z Function - fixed money wage rate
380
360
340
320
300
10
10.2
10.4
10.6
10.8
11
Employment N (000s)
11.2
11.4
11.6
11.8
Some economists argue that costs rise even more quickly than the possibility of rising wages as employment
increases. This relates to the issue of whether there are increasing or decreasing returns.
In the General Theory, Keynes adopted the Classical view that firms faced increasing costs (decreasing returns)
driven by the assumption of diminishing marginal returns. That is, productivity declined as employment rose
given the fixed supply of capital. We will return to this issue in Chapters 10 and 11 when we study the labour
market in more detail.
As we saw in Figure 9.1, we adopt the operational assumption in this Chapter that returns are constant.
The point is that if productivity declines as employment rises, then the Z-schedule will become steeper as
activity increases independent of what happens to money wage rates.
MORE HERE
Later in this Chapter we will reconstruct the aggregate supply side of the economy in real terms and relate price
and output.
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Some notes on Aggregate Supply Part 2 Posted on Friday, July 13, 2012 by bill
A basic insight in macroeconomics is that one person’s spending is another person’s income. We might also say
that for every dollar spent by a purchaser, the income of the seller goes up by the same amount. As we saw in
Chapter 5 National Income and Production Accounts, the total value of all goods and services produced each
period (say a year) is exactly equal to the national income received by all recipients over the same period.
In understanding aggregate supply, we begin with a single firm. Each firm purchases inputs (raw materials,
labour etc) in the hope of transforming these inputs into goods and services (intermediate and/or final) which
can be sold for money.
Applying the spending equals income accounting rule, we know that the total revenue for a firm (its sales)
equals the sum of its total costs and its realised profits in each period. Profits are simply the excess of sales
revenue over total costs. Realised profits in a capitalist system are a residual that are observed after production
and sales have taken place. The firm expects to make a profit but may underestimate costs or overestimate total
revenue and end up making a loss.
As an example, assume that a firm generates sales revenue equal to $20 million in the current year. To achieve
this revenue it has to incur costs in the form of wages and salaries, costs of raw material bought and used in
production, costs associated with its plant and equipment (for example, rents, interest payments on loans) and
other operational costs.
The costs of production are itemised as follows:
Wages and salaries
$12 million
Raw materials
$4 million
Plant and Equipment costs (rent, interest etc…)
$2 million
Other costs
$1 million
Total costs of production
$19 million
From this example, we calculate that the firm received profits of $1 million. We have abstracted from taxes and
depreciation here to avoid getting into discussions about the difference in the National Accounts between
National Income and Gross National Product which we explained in Chapter 5 (see also Footnote 1, page 252
Tarshis, 1947 for an explanation).
All the costs of production are paid to workers, suppliers of raw materials, property owners, banks who provide
finance and the like. For those recipients the costs of production for the firm are income flows.
Clearly, these accounts are found in all the firms producing goods and services in the economy. The firms in the
economy are also interlinked because one firm may purchase raw materials or plant and machinery etc from
other firms. So, some of the costs of production for the firm depicted in the table above will be the sales revenue
of other firms.
So for each firm’s revenue we can track the flow of spending by that firm throughout the economy to satisfy
ourselves that total spending equals total national income.
In the 1947 textbook – The Elements of Economics – by Lorie Tarshis we read (page 254):
… a firm’s sale receipts in any period are equal to the sum of its costs and profits for that period.
All items of cost can be identified with someone’s income: wage and salary costs directly; and
costs for raw materials after one or several steps in the analysis of the activities of firms that
supply raw materials to our firm, or to the supplying firm, and so on. Likewise, the profits earned
are, of course, the income of the firm’s owners. Hence a firm’s sale receipts in any period equal
the incomes earned in producing what it sold.
He produced this diagram (his Figure 57, page 254) to represent the relationship between sales revenue at the
firm level and national income at the macroeconomic level.
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THIS DIAGRAM TO BE PROFESSIONALLY DRAWN
Figure 9.3
Firm sales and national income
Source: Tarshis, L. (1947) The Elements of Economics, Houghton and Mifflin, Boston
Block A1 is the total revenue for Firm 1 in the current period. It uses that revenue to pay wages and salaries
(W1), rent and interest (L1), and raw materials purchased from other supplying firms (F 1).
The profits for Firm 1 (P1) = A1 – [W1 + L1 - F1]
Total income generated by Firm 1 = (P1) + W1 + L1 + F1 = A1
Assuming Firm 2 is the only one raw material supplier to Firm 1, then its total revenue (A2) is equal to (F1), the
purchases of raw materials by Firm 1.
Firm 2 also incurs costs in generating the revenue (W2), (L2), (F2) and generates profits (P2).
Total income generated by Firm 2 = (P2) + W2 + L2– F2 = A2
The diagram shows that F2 is the revenue of Firm 3 (A3), which is similarly distributed to providers of inputs.
The logic is to note that F1 = A2 and F2 = A3 and so on until all the inter-firm transactions are exhausted. We are
abstracting here from other inputs that firms might supply each other.
Using that logic we can see that total revenue generated in the economy (sales or spending) is equal to total
incomes produced. Total incomes are the sum of profits and other incomes.
In Chapter 5, we were warned to be careful to avoid double counting when assessing the national income in any
period.
[NOTE: Reiteration of Double Counting here]
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9.3
Price Determination
Clearly, firms seek to generate a profit over and above the costs of production. How does it go about setting the
price that it will accept for its output?
Firms are assumed to operate in a non-competitive economy. You may have considered the case of perfect
competition in a microeconomics course where firms are assumed to have no price setting discretion because the
market is so large and firms are assumed to be so small.
We are thus introducing oligopoly as a basic assumption rather than the mainstream use of perfect competition.
Firms are thus considered to be price-setters rather than price-takers. Firms are assumed to fix their prices as a
mark-up over costs. Economists are divided about the determinants of the mark-up and the costs considered
relevant in the pricing decision by firms.
Further, debate remains as to whether the mark-up is invariant to the state of demand. However, the use of the
mark-up as a basic description of firm behaviour in the real world is difficult to dispute.
In the real world, firms typically have discretionary price-setting power and seek a rate of return on the capital
employed, which necessitates that they generate a profit margin over total costs of production.
The total price per unit sold must therefore cover its unit costs of production plus the profit margin. How we
account for overhead and other fixed costs is debatable. They may be included in unit costs or, alternatively, the
profit margin may be considered to be a gross amount which includes overheads and other fixed costs plus net
profits per unit.
Firms are thus assumed to employ a mark-up pricing model such that:
(9.2)
P = (1 + m)[W/LP]
where P is the price of output, m is the per unit mark-up on unit labour costs, W is the money wage and LP is
the measure of labour productivity. The variable LP is defined as the units of output per unit of labour input.
If LP = 0.5 then the average product of labour is such that 2 labour hours are required to produce one unit of
output. If the money wage (W) was $5 per hour, then the unit labour costs (cost of a unit of output) would be
$10.
The mark-up (m) is set to provide a surplus above the direct unit labour costs to account for fixed (overhead)
labour and other costs in addition to a provision for profits (return on equity). The amount of profit desired is
related, in part, to the amount of investment that the firms plan to undertake because retained earnings are an
important source of internal finance that the firm taps to reduce its exposure to higher costs of external funding
of projects.
In the short-run, the price will be rigid with the firm supplying output according to demand. Price changes
would occur when there were changes in the money wage rate or other variable costs, the mark-up (margin), or
trend labour productivity. Trend labour productivity is used here to differentiate it from the cyclical swings that
occur in labour productivity, which we consider in Section 9.X of this Chapter.
The mark-up (m) is a reflection of the market power of the firm. The higher the market power, the higher will be
the margin. In more competitive sectors, the margin will be lower than less competitive sectors. Changes in
competitiveness in a sector will, over time, lead to changes in the size of the mark-up.
If in our example, the mark-up (m) is set at 40 per cent, then the firms will price its output at $14 per unit ($10
by 1.40).
[NOTE - A SECTION ON AGGREGATION TO GO FROM FIRM MARK-UP TO ECONOMY-WIDE PRICE
RULE]
The features of this approach are as follows. First, prices are unambiguously a function of costs.
Second, firms use their price-setting discretion to generate a monetary surplus above average direct costs. This
monetary surplus is designed to cover profits. Importantly, profits are considered to be influenced in the shortrun by the ability of firms to realise the mark-up on unit costs. Factors which may squeeze the mark-up will
accordingly also squeeze profits.
Third, the mark-up impacts directly on the real wage that the workers receive. If total marked-up costs only
embrace (for simplicity) wage costs then total wage costs, are the product of the money wage rate W times the
number of workers employed N. That is, total wage costs = WN.
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A simplified price mark-up model would be in this case:
(9.3)
P = (1 + m)WN/Y
where all the terms are as defined previously.
We can re-write this equation as:
(9.4)
Y/(1 + m) = WN/P
and further re-arrange it to get:
(9.5)
W/P = (Y/N)/(1 + m)
which says that the real wage (W/P) is dependent on the average productivity of labour (Y/N) and the size of the
mark-up. The larger the mark-up (m), other things being equal, the lower is the real wage.
Fourth, the volume of profits (as distinct from the per unit profit) is dependent on the size of the mark-up –
which influences the per unit profit – and the volume of output sold in any one period. The latter is determined
by the state of aggregate demand in the economy and as we saw in Chapters 7 and 8, is determined by the level
of household consumption expenditure, private investment expenditure, net exports and government spending.
Firms plan to increase profits by raising the mark-up. They might also plan to raise investment spending if they
are to realise the extra profits especially since the implied real wage squeeze is likely to have detrimental effects
on disposable income received by households and hence consumption expenditure. In Chapter 12, we consider
investment behaviour and introduce the famous Kalecki Profits Equation, which shows that firms generate
profits according to what they spend.
Figure 9.4 shows the way in which the price set by all firms (P 0) at some point in time is distributed as incomes.
Here the current level of output being produced is Y0. The price P0 is a mark-up on total unit costs allowing for
fixed costs and overheads and a net profit margin.
Total revenue for the economy as a whole is the area defined by P0 times Y0 and the distribution of that level of
output as income is shown by the areas below the price line.
Firms thus supply the output that is demanded at the price P0. They produce a given level of output according to
their expectation of total spending in the economy. The diagram below makes no presumption that the level of
output Y0 is consistent with that expectation. It is, in fact, total output sold and may or may not satisfy the firms’
expectations.
In that sense, the net profits generated may be below or above the level that the firm aimed to achieve at the
beginning of the production period.
Figure 9.4
Output, sales and national income
PRICE
P0
Net Profits
Gross Margin or
mark-up (m)
Fixed costs and overheads
Variable costs including labour and
raw materials
Unit costs
Y0
OUTPUT
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Fifth, usually mark-up theories assume that the immediate impact of changes in demand on the mark-up and
hence prices is small. For the planning period ahead, firms calculate their costs and desired profits on the basis
of an expected level of output which they believe they can sell. Deviations in this expected level of demand
promote output changes rather than price changes.
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9.4
The General Aggregate Supply Function
Before we consider these complicating factors – changes in productivity, changes in competitiveness – it is
useful to consider what the price determination rule means for the shape of the aggregate supply function.
If we assume that m, W and LP are constant in the short-run then the aggregate supply curve would be a
horizontal line in the price-real income graph up to some full capacity utilisation point (Y*). Economists
sometimes refer to a horizontal line in this context as being perfectly elastic. Firms in aggregate will supply as
much real output (goods and services) as is demanded at the current price level set according to the mark-up rule
described above.
Figure 9.5 is similar to Figure 9.4 but adds the full capacity utilisation level of real output (Y*) to derive the
General Aggregate Supply Function (AS). This shaped AS function is sometimes referred to as a reverse-L
shape for obvious reasons.
The horizontal segment has been explained by the price mark-up rule and the assumption of constant unit costs.
But why does it become vertical after full employment?
After this point, the economy exhausts its capacity to expand short-run output due to shortages of labour and
capital equipment. At that point, firms will be trying to outbid each other for the already fully employed labour
resources and in doing so would drive money wages up. We will return to this possibility later in this Chapter.
Under normal circumstances, the economy will rarely approach the output level (Y*) which means that for
normally encountered utilisation rates the economy faces constant costs.
There is some debate about when the rising costs might be encountered given that all firms are unlikely to hit
full capacity simultaneously. The reverse-L shape simplifies the analysis somewhat by assuming that the
capacity constraint is reached by all firms at the same time. In reality, bottlenecks in production are likely to
occur in some sectors before others and so cost pressures will begin to mount before the overall full capacity
output is reached.
This could be captured in Figure 9.5 by some curvature near Y*, thus eliminating the right-angle. We consider
this issue in more detail in Chapter 11 Inflation and Unemployment.
Figure 9.5
The General Aggregate Supply Function (AS)
PRICE
General Aggregate
Supply Function
Pt
Y*
OUTPUT
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9.5
Some Properties of the General Aggregate Supply Function (AS)
The AS equation is simply the price determination model equation (9.2), which shows that in the short-run, the
behaviour of the aggregate supply in the economy depends on m, W and LP.
Accordingly:

If the money wage rate rises, other things equal, the unit cost level rises and the firms would
translate this into a price rise via the constant mark-up.

If there is growth in labour productivity (LP) as a result of say, increased labour force morale,
increased skill levels, more technologically-based production techniques, better management,
and the like, then unit costs (W/LP) will fall. This means that the firms can generate the same
profit margin at lower prices. The AS function would thus shift downwards by the extent of
the decline in unit costs.

Variations in the mark-up (m) will cause the price level to change. Increases in industrial
concentration, more advertising etc may lead to firms being able to increase the overall profit
margin that can be sustained. Tight conditions in the goods and services market, where sales
are constrained, may lead firms to reduce the mark-up desired as they all struggle for market
share. This could occur as a result of flagging sales and strong trade unions pushing
(successfully) for wage increases. Thus to avoid losing market share, the firms may choose to
absorb some of the cost rises into the margin.

If employment is below full employment and thus Y actual < Y*, which means there is an
output gap present, then increases in aggregate demand (spending) which are seen by firms to
be permanent will result in an expansion of output without any price increases occurring. If
the firms are unsure of the durability of the demand expansion, they may resist hiring new
workers and utilise increased overtime instead. That is, they initially respond to the increased
aggregate spending by increasing hours of work rather than persons employed. The higher
costs (as labour productivity falls) are likely to be absorbed in the profit margin because firms
desire to maintain their market share overall.
[NOTE: There is a section here on labour productivity - technology - costs of production]
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9.6
The Mark-up, the Real Wage, Conflict and Inflation
[NOTE: This section may move to Chapter 11 Unemployment and Inflation]
The General Aggregate Supply Function provides a framework for examining the incidence of inflation and is
based on three broad features:

The goods and services market is assumed to be non-competitive (oligopolistic). This means
that in most industries a few firms dominate price setting. Smaller firms are forced to price
accordingly or lose access to the market.

The labour market is characterised by wage setting processes that depend on bargaining
between workers and firms, sometimes directly and other times via specific wage setting
institutions.

Firms access credit through the banking system to finance enterprise commitments in advance
of sale. Changes in the broad money supply (to be considered in detail in Chapter 14 Money
and Banking) arise from the demand by firms for credit.
The introduction of oligopoly as a basic starting point for the analysis, rather than the mainstream use of perfect
competition, allows us to focus on inflation as the outcome of conflict over the distribution of income between
competing groups in the economy (wage earners and profit receivers).
Four main groups in the economy that have a stake in the income which the economy produces in the current
period can be identified:
1.
Workers struggle to increase their command over real goods and services via their real wages.
2.
Firms seek to expand their profits.
3.
Suppliers in the Traded-goods sector gain revenue by providing inputs.
4.
The government sector seeks to tax the non-government sector to create space for its own
expenditure plans.
These competing claims are expressed in nominal terms. That is, a monetary claim on total income.
These nominal claims for the available real income that the economy produces are clearly in conflict with each
other. There is no reason why the sum of the competing nominal claims should be exactly equal to the level of
real output produced in any period.
Workers may try to raise their real wage by pushing for higher money wages, which may be frustrated by price
rises as firms react to protect their profit margin. Firms may be the aggressors by increasing the mark-up which
then elicits what we call real wage resistance – workers try to increase money wages because they resent their
real wage being cut. This wage-price (or price-wage) struggle has the potential to generate inflation if left
unchecked.
Various methods can be used by the different groups to reconcile the nominal claims on real output if they are
mutually incompatible.
Two important sources of resolution in the real world are relevant:

Changes in the level of aggregate demand and output may be used to resolve the conflict. The
volume of profits depends, in part, on the level of demand as does the size of the mark-up. A
recession, induced by contractionary fiscal and/or monetary policy can squeeze profits by
reducing the ability of the firms to pass on (that is, realise) costs. A recession also raises the
level of unemployment and may quieten the aspirations of the worker for higher real wages
(that is, quell any real wage resistance) as workers begin to fear loss of employment.

The government, fearing the political consequences of a policy-induced recession, may try to
introduce an incomes policy to break into the competition between workers and firms for
increased real income.
Inflation pre-dates these reconciliation attempts. Thus inflation is seen as the outcome of one or more groups in
the economy attempting to expand their own share of national income. With a given national income, one group
can only achieve an increase in its share if another group is willing to reduce their share.
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That is, one group’s gain is another group’s loss. Each group has at its disposal the means to protect its own
share, although the ability to enforce these means varies according to the state of the economy, among other
things.
The obvious response by a threatened group is to raise its own price (money wage, product price, raw material
supply price, or tax rate) to compensate for the loss of real income. Inflation will continue until a resolution to
the conflict is found.
Typically, this outbreak in prices is complicated by the development of inflationary expectations among the
competing groups. As inflation increases the various groups plan price rises in advance to cope with the
expected reactions of the other competing groups. The continuation of inflation presupposes that each group
strives, and is able to pass on the loss in its real income onto another group or groups. Ultimately, this implies
that the money supply must increase unless all the price rises are absorbed via increases in the velocity of broad
money. We consider these issues in Chapters 11 and 14.
However, this is where the existence of credit money is relevant. The money supply is endogenous and highly
responsive to the demand for credit by the non-government sector. The question of finance is important because
production involves the commitment of resources by firms which must be paid for in advance of the realisation
of revenue, via the sales of output.
Increases in planned expenditure by firms may arise from plans by firms to expand output to increase their
market share or from the fact that input prices have risen. In either case, the firms increase borrowing from the
banks (assuming credit-worthiness) and the money supply increases.
The increasing money supply is the obvious way that the inflation process can gain momentum. At the firm
level, if the firm can gain loans to finance higher input prices, which it then passes on to final consumers and
pays for the loans by raising its prices, then inflation can take hold.
If the firm was not able to gain this increased finance on satisfactory terms from the bank and therefore the
money supply would not validate the initial push for higher prices, then it would have to employ some
combination of reduced input purchase and/or lower prices for its output.
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Productivity and the response of firms to the business cycle Posted on Friday, July 20, 2012 by bill
9.7
Factors Affecting Aggregate Output per Hour
What factors determine the impact of change in hours of employment on aggregate output? Over time, many
influences are at work. Such things as, improving technology, changes in the average quality of labour from
increased education and health, changes in organisational and management skills, will steadily allow more
output to be produced from a given quantity of inputs.
In seeking to understand short-run employment and output determination, we adopt the view that these
influences work slowly over time and so we abstract from them in our short-run analysis.
The neo-classical production function analysis, which is standard in most textbooks, assumes that in the shortrun, with all other productive inputs (capital, land etc) fixed, output will increase at a decreasing rate as more
hours of employment are used by firms.
This is the so-called Law of Diminishing Marginal Productivity and allows economists of this persuasion to
postulate an increasing marginal cost relationship with respect to output (costs increase at an increasing rate as
more output is produced). In turn, this leads to a decreasing labour demand function with respect to the real
wage. These relationships are derived from the assumption that firms produce and employ such that their profits
are maximised at given price and real wage rates.
The validity of “the Law” has been the subject of considerable controversy. In essence it is a theoretical
construct – an unproven assertion. No conclusive empirical evidence has ever been assembled to substantiate the
“the Law” as a reasonable generalisation of production relationships in modern monetary economies.
On the contrary, there is a mass of empirical evidence available, derived from actual studies of business firms. to
support the view that costs of production are constant in the relevant or normal range of output and that the Law
of Diminishing Marginal Productivity is not applicable.
In fact, a strong positive relationship between output per hour and the business cycle is observed in the real
world. We call this a pro-cyclical movement in output per hour, which means that output per unit of labour input
increases as the level of production and employment increases.
The pro-cyclical pattern of labour productivity (output per hour) means that costs per unit of output will not
increase as output increases. Total costs will obviously rise but the per unit costs will decline as the economy
approaches full capacity.
If W is the money wage rate and N is total employment measured in hours, then total labour costs in any period
are:
(9.6)
C = W.N
If Y is real output, then unit labour costs (ULC) are the cost incurred for each extra unit of output, which is
given as:
(9.7)
ULC = W.N/Y
Noting that (Y/N) is output per unit of input (or labour productivity), we can re-arrange Equation (9.8) as:
(9.8)
ULC = W/(Y/N)
In other words, all the results that depend on the operation of the Law of Diminishing Marginal Productivity are
no longer valid approximations of the way the economy works. In particular, the shape of the aggregate supply
curve and the labour demand curve at both the firm and aggregate level will not bear neo-classical proportions.
This shows that if the money wage rate is fixed, then the change in ULC will be driven by changes in labour
productivity. If output per hour rises as economic output increases, then unit labour costs fall as the economy
approaches its peak.
Consider Figures 9.6 and Figure 9.7, which show real output per person and real output per hour in the US
manufacturing sector, respectively. The shaded areas are the NBER recessions.
Both measures of labour productivity are pro-cyclical. During a recession, when output is falling, productivity
falls. This is in contradistinction to the Law of Diminishing Marginal Productivity.
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The US manufacturing sector behaves in a similar way with respect to pro-cyclical movements in labour
productivity to all advanced economies.
[Note: the Figures will be reconstructed in the final text from our own database and conform to the style of the
textbook]
FIGURE 9.6
US Manufacturing Output Per Person Employed
130
120
(Index 2005=100)
110
100
90
80
70
60
50
40
1985
1990
1995
2000
Source:
US
Department
of
Labor
–
http://research.stlouisfed.org/fred2/series/PRS30006163?cid=32349
2005
Bureau
2010
of
Labor
2015
Statistics
Note: Shaded areas indicate US recessions
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Figure 9.7
US Manufacturing Output Per Hour of All Persons
120
110
(Index 2005=100)
100
90
80
70
60
50
40
1985
1990
1995
2000
2005
2010
2015
Source: US Department of Labor – Bureau of Labor Statistics http://research.stlouisfed.org/fred2/series/OPHMFG?cid=32349
Note: Shaded areas indicate US recessions
The theory of production we present here is based on several stylised facts from the real world:
1.
Economies are rarely at full employment and the existing capital stock is rarely fully utilised.
Idle machines typically accompany idle workers when the economy goes into a downturn.
2.
The capacity of firms to substitute one input (say, labour) for another (say, capital) in the
production process is limited. In the real world, a typical firm employs a number of machines
and types of equipment, which have more or less fixed labour requirements.
For example, say a firm provides services from an office and each worker requires a desk, a chair and a
computer to perform their duties. In the usual course of events (barring putting on an extra shift) the firm has to
increase its capital and labour in the proportions defined by the technology being used to expand output.
It doesn’t violate reality too much to simplify this stylised fact by assuming what economists refer to as fixed
input coefficients technology.
Take a trivial example of a cleaning firm which uses brooms as its principle technology. It services a contract to
sweep rooms in office blocks each day. It is hard to imagine two workers pushing one broom or one worker
pushing two brooms. So to start production, the firm needs to combine its productive inputs in a fixed ratio (in
this case, 1).
If the firm gained contracts for more office cleaning which exceeded the capacity of one cleaner, then it would
have to (given the technology being used) add another broom for the second worker to use and so on. So the
productive inputs are added in fixed proportions defined by the technology being used.
What will the level of employment in this firm depend upon?
The firm will hire according to the demand for its services and its demand for labour will not be very sensitive
to wage changes. Clearly, it will make decisions about viability of its operation based, in part, on wage costs.
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But on a day-to-day basis, if it is profitable at the current wage rates, then it will increase or decrease its demand
for labour based on the revenue it can anticipate from sales.
In other words, effective demand drives labour demand.
Cutting wages would only redistribute total revenue towards profits, which might damage aggregate demand as
workers will have less income to spend.
The neo-classical production theory, based on the Law of Diminishing Marginal Productivity, considers that
firms are able to substitute labour and capital freely and if the price of labour increases in real terms, the firms
will quickly use less labour and more capital.
The problem with this conception is that firms are rarely able to substitute inputs quickly and to use more capital
and less labour typically requires a total change in technology. Real wage movements would have to be very
large to justify the firm scrapping their existing technology.
While the fixed input ratio assumption is extreme and shows the essential relationship between effective demand
and employment, it doesn’t alter the story if we consider the more realistic case of limited substitution
possibilities.
Consider how firms might act. Based on the current costs pertaining to capital and labour and the available
technology, a typical firm will select the capital stock necessary to produce expected output. In making that
decision, they are also committing to a certain labour demand given the relationship between the technology
being used and the input proportions required.
Given the relative costs of labour and capital, a firm will reasonably chose the lowest cost technology it can
afford. In turn, this will set the capital-labour input ratio that it will be more or less bound by in the coming
production period.
Is the capital-labour ratio easily changed?
As a result of capital being specifically embodied in the form of machines, equipment, buildings and the like –
once installed there is very little substitution possible.
The firm knows that if it needs to produce more output to meet the market demand then it will have to increase
its demand for more labour and capital, in the proportions governed by the technology in use.
Adding more labour alone will not increase output just as adding more capital alone will not increase output.
How does this affect our understanding of production costs?
In this economy, firms will adjust their input use to meet the fluctuations in demand for output. If orders decline,
then their demand for inputs will decline. Both capacity utilisation and labour utilisation will decline.
But for the firm, capital becomes what economists call a free good. Relative to its purchase and installation costs
the variable costs of running the capital are usually low. Economists call the major costs involved sunk, which
means that the firm has already incurred them whether they run the plant or not.
Accordingly, the firm will use as much capital as is required to produce the current output that is being
demanded. When demand falls, the firms simply leave some proportion of their capital stock idle.
But in doing so, they shed labour because the variable costs of the labour input are relatively high when
compared to the fixed hiring and related costs.
What role does the real wage play in this? Even if the real wage fell to zero the firms would not employ more
workers if aggregate demand didn’t justify it. Firms will not produce if there is not a prospect of sale (barring
the small proportion of production they keep as inventories to smooth our orders).
How would a firm react to an increase in aggregate demand?
If there has been a prolonged downturn then we would observe idle capital and labour (unemployment). The
unemployed workers are willing to work at the current wage rates but there is no demand for their services
because effective demand is too low.
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While we have reason to believe that unit costs decline as capacity utilisation increases, fixed factor input
proportions mean that firms face constant unit costs in normal ranges of production. That is, we are assuming
that money wages are fixed in the short-run and labour productivity is constant.
If the firm received increased orders for its output then it will seek to maintain its market share by increasing
output. Assuming constant unit costs the firm will bring its idle capital back into production and hire more
workers.
There would be no price pressures likely because there would be no pressure on costs. As output rises, the
demand for labour increases at a constant real wage.
This suggests that the Aggregate Supply curve is very flat over the normal range of output. Increases in nominal
demand will be met by increases in real output (income).
There are several reasons why firms might be reluctant to increase prices (even though costs might rise
temporarily as we explain below) or reduce them when aggregate demand falls.
First, industries are characterised by a few dominant firms that exercise market power.
Second, consumer loyalty to products of other firms means that they will not react to a price fall in other similar
products.
Third, there are significant costs involved in adjusting prices. Firms have to produce new price tags and
catalogues.
What factors might explain the observed pro-cyclical movement in labour productivity?
The following factors help to explain the observed pro-cyclical pattern of labour productivity.
First, a dimension of the aggregation problem appears when we consider that the value of output per hour of
employment varies considerably among the range of firms and industries that comprise the total economy.
For example, the manufacture of high-tech electrical goods would have a much greater output per hour of labour
input than say the provision of hairdressing services.
It can be shown that even if diminishing returns were operating at the individual firm level (as assumption not a
fact) such a constraint need not be functional at the aggregate level.
If the proportions of output attributable to individual industries change as output increases (a fact observed in
the real world), and the changes are such that the industries where diminishing returns are most apparent lose a
disproportionate amount of their share in total output, then labour productivity can increase. This hypothetical
example merely indicates the dangers that are involved in adding up a set of non-linear relations operating at the
micro level. It is beyond the level of understanding that is required to master the material in this textbook.
Second, and less esoteric, as far as the individual firm is concerned, the actual real world relationship between
changes in labour hours and changes in output may not exhibit diminishing returns because other productive
inputs may vary in the same proportion as the labour input.
Thus the neo-classical assertion that capital, in the form of specific plant and equipment, is always held constant
confuses the distinction between the stock of capital in value terms – that is, its monetary worth and the flow of
services that the stock produces which is revealed by the rate of capacity utilisation.
While the stock of capital changes only slowly over time, utilisation rates can vary in the short-run. Firms will
leave machines idle as their production plans are changed in the face of declining demand for their products.
Unused machines and idle factory space is unlikely to raise the productivity of the remaining machines and
equipment in use.
As production is increased when the firm believes that it can sell more output, unused machines are turned back
on and unemployed workers are assigned to them. There is no reason to assume that output per unit of labour
input on these machines would be any different to that derived from the plant that was kept active during the
downturn.
Third, and of great practical importance is the observation that most firms desire to maintain long-term relations
with their labour forces. The reason for this behaviour by firms relates to the fixed costs of hiring (recruiting,
training and redundancy provisions) and to the need to maintain morale among the workers.
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Efficiency is crucially dependent on the feelings that the workers have towards security and the like. Firms are
also reluctant to dismiss specialised workers for fear of losing them permanently.
As a consequence, employment tends to fluctuate less violently than output or production. Labour productivity
therefore falls in a recession and rises in booms.
In booms, output grows quickly, but the firm which has hoarded labour in the recession, does not immediately
expand employment. It merely works its existing labour force more intensively – that is, adjusts hours of work
rather than persons employed.
These adjustments are reinforced by the fact that hiring and firing decisions depend on future or expected sales.
Firms will increase employment of new workers and incur the fixed costs if it expects to maintain a higher sales
level.
If the rise in demand is not expected to be permanent (or the firm is not sure of its durability) then it will use
overtime as the cheapest adjustment.
So in the short-run, costs might rises as overtime premiums are paid as the firm decides whether the increase in
demand is permanent or transitory.
Once it realises that the sales will remain at the higher level, costs fall again as new staff are hired and overtime
declines.
[NOTE: the DISCUSSION NEXT, TURNS TO THE CLASSICAL VARIANT]
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References
Tarshis, L. (1947) The Elements of Economics, Houghton and Mifflin, Boston
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