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Supply and aggregate supply are unrelated concepts

Summary:
The AS/AD model that we teach our students is misnamed, as it has nothing to do with the supply and demand model used in microeconomics. To take one simple example, the vast majority of industry supply curves are almost perfectly elastic (horizontal) in the long run. The long run aggregate supply curve is almost perfectly inelastic (i.e. vertical.) These are just completely unrelated concepts. This can help us to evaluate some issues raised by Tyler Cowen: If you think “stimulus” is effective right now, presumably you think supply curves are pretty elastic and thus fairly horizontal. That is, some increase in price/offer will induce a lot more output. If you think we should hike the minimum wage right now, presumably you think supply curves are pretty inelastic and

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The AS/AD model that we teach our students is misnamed, as it has nothing to do with the supply and demand model used in microeconomics. To take one simple example, the vast majority of industry supply curves are almost perfectly elastic (horizontal) in the long run. The long run aggregate supply curve is almost perfectly inelastic (i.e. vertical.) These are just completely unrelated concepts.

This can help us to evaluate some issues raised by Tyler Cowen:

If you think “stimulus” is effective right now, presumably you think supply curves are pretty elastic and thus fairly horizontal. That is, some increase in price/offer will induce a lot more output.

If you think we should hike the minimum wage right now, presumably you think supply curves are pretty inelastic and thus fairly vertical.  That is, some increase in price for the inputs will lead not to much of a drop in output and employment, maybe none at all.  The supply curve is fairly vertical.

What matters for stimulus is the short run aggregate supply curve.  What matters for the minimum wage is the long run industry supply curve.  These two curves are especially unrelated.

[There also the question of whether industry supply curves even exist. Minimum wage proponents usually deny it–claiming that industries are monopolistically competitive.  The evidence suggests that industry supply curves do exist.]

I oppose both fiscal stimulus and minimum wage laws, but for reasons mostly unrelated to supply elasticities.

If you favor a minimum wage hike because you think the demand for labor is inelastic, does that mean you don’t see “downward sticky wages” as a big problem?  After all, the demand for labor is inelastic, right?

Minimum wage laws should be evaluated on the basis of their long run effects.  Proponents probably believe that a good chunk of the higher minimum wage will come out of the pockets of other workers (via higher prices.)  I’ll have to pay more for fast food.  And the empirical evidence supports that claim.  So minimum wage proponents would claim no inconsistency in their views on minimum wages and sticky wages.  But this is one problem with the argument for higher minimum wages.  If they raise prices then they probably also cost jobs.  (My own view is that the bigger problem with minimum wage laws is that they reduce non-wage compensation.)

This is a good point:

If you favor a minimum wage hike, do you criticize wage subsidies because inelastic demand for labor means most of the value of the wage subsidy will be captured by the employer? Or do you somehow want both policies at the same time, because they both involve “government helping people”?

I support wage subsidies to low wage workers because I believe that minimum wage industries tend to be highly competitive, with zero long run economic profits.  And for exactly the same reason I oppose minimum wage laws.

Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment". In May 2012, Chicago Fed President Charles L. Evans became the first sitting member of the Federal Open Market Committee (FOMC) to endorse the idea.

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