An increase in aggregate consumption demand occurs from government monetary policy. Will:
Businesses increase their prices.
OR
Businesses increase quantity supplied.
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I believe (correct me) that Keynes’s assumption was that businesses would undergo capital/labor investment and a degree of ‘risk’ (however distorted that may be) to increase the quantity that they supply. It seems to me, that upon an increase in AD, that there might be a stronger incentive to simply increase prices to get the best returns out of that new demand.
Example: Assume that I have a donut shop and i am faced with, overnight, a doubling from 100 people to 200 people wanting to buy a donut at my pre-AD-increase prices. I can either incur cost and risk to make twice as many donuts (assuming I make exactly the amount of donuts I sell), or just ask my local micro-economist to tell me what the highest price I could charge for my current quantity maximum of 100 donuts is. Which plan of action would you recommend to the donut owner?
The situation above, of course, focuses on an isolation of increased AD – it does not include any mention of competition. My intuition is that, if the donut market is perfectly competitive, then the labor investment and innovation in that market stays the same before AD and after AD. Upon the initial increase, prices will increase. If there is a viable investment that would increase quantity supplied and lower prices to compete better and incurr demand from more people – and increase overall efficiency in that economy – than would it be made regardless of changes in aggregate demand?
Im sure the answer to this is simple and that i’m just kind of slow, this is just where my train of thought has led me I guess.
In: 1
The assumption is that in a well-regulated and competitive market, the increase in demand will result in increased supply because the suppliers are incentivized to produce more in order to take the market share before their competitors can. If you produce 10 items and raise profits from $10 an item to $11 an item, does that offset the loss in profits from producing 20 items and selling them for $9 profit an item? $110 in profit isn’t more than $180 in profit.
There is a natural downward pressure on prices from competition. And the only way to get around it is through collusion for everyone to raise prices at once. That is hard to do in a competitive market when any single actor can gain much more profit from undercutting everyone else and taking their competitor’s market share.
Which is why monopolies/oligarchies are considered harmful to a free market system. And why we have anti-trust (as in breaking trust between market players to raise prices together) laws and we heavily regulate situations where natural monopolies exist, like the power grid/utilities or public transit.
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