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
If you have a “traditional” supply curve that slopes upwards but isn’t completely vertical, businesses will optimally increase BOTH prices and quantity supplied. In your donut shop example, we have to assume you have increasing marginal costs (somewhat unusual for an individual business but more sensible when thinking about *aggregate* supply). You want to set a price such that you don’t lose money on the last donut you sell. Maybe the 150th donut costs $2, and a price of $2 will drive away 50 of the new customers. Making more donuts means you have to raise prices above $2, more than 50 customers will leave, and you end up with unsold donuts. Making fewer donuts means you’re leaving money on the table from the extra donuts you could have made (though if you’re a donut monopolist, you may optimally underproduce donuts while charging a high price).
Horizontal supply curves reflect constant marginal cost. Each donut costs exactly the same to make, so businesses will happily supply exactly the number of donuts demanded, provided the market price is at least the marginal cost. Vertical supply curves reflect infinite marginal cost. There are only 100 donuts in the whole world and we cannot make more, so prices must be set such that demand is no more than 100.
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