Essential definitions

Short-run aggregate supply

Real output firms are willing to produce at each price level while some input prices are slow to adjust.

Unit labour cost

Labour cost per unit of output, linked to wages relative to productivity.

Start with costs and production

Short-run aggregate supply, SRAS, is the output firms will produce at each general price level while some wages and other input prices are slow to adjust. If selling prices rise before costs do, additional production becomes more profitable. Firms expand output, giving SRAS its upward slope. Bottlenecks make expansion increasingly costly near capacity.

Use real GDP horizontally and the general price level vertically. A change in that price level moves along SRAS. A change in costs at every price level shifts the curve. For example, more expensive fuel makes a delivery firm's existing output costlier. Across many firms, less output is profitable at each price level, shifting SRAS left.

Identify the cost per unit

Money wages alone do not establish a labour-cost change. Unit labour cost is labour cost divided by output. A worker paid 24 currency units an hour producing six items costs 4 per item. If pay and output per hour both rise, calculate their combined effect before predicting a shift.

Energy, raw materials, imported components, land and capital-service costs can also shift SRAS. A weaker currency raises imported-input costs when foreign prices stay unchanged. Indirect taxes on production or sales can add costs; lower relevant taxes or better productivity can reduce them. A tax on profit does not automatically change the marginal cost of producing a unit.

Read an adverse supply shock

Start at E1, where AD meets SRAS1. Shift supply left to SRAS2 after fuel costs rise. E2 is the new intersection with unchanged AD. Project both points to the axes: the price level rises and real output falls. Lower production can reduce employment. This combination is called stagflation.

The diagram compares price levels. Sustained inflation requires ongoing pressure or further adjustment, rather than one shift alone. Supporting demand after a supply shock may protect jobs but raise prices further; reducing demand can curb price pressure while deepening the output loss. First explain the shock, then evaluate this policy choice.

Apply and evaluate

• A temporary energy shock and a persistent productivity loss require different responses.
• Firms may absorb some costs in profit margins; cost pass-through is not automatically complete.

Real-world application