Aggregate Supply and Demand Analysis

This solved assignment analyzes the consequences of a decline in aggregate supply within an economy. It explains how a decrease in aggregate supply leads to a leftward shift of the SRAS curve, resulting in a fall in real GDP (Y) and a rise in price levels (P). The text further elaborates on the potential causes of such a decrease, including contract-based employment practices that may discourage worker productivity.

Running head: ECONOMIC PRINCIPLES
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Economic Principles
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Question 2
Productive and Allocative Efficiency in Perfect Competitive Firm
Productive Efficiency
Productive efficiency takes place if a firm produces at the lowest point of the average
cost curve. When a business exhibit productive efficiency, it shows that there is no excess
capacity and that the available resources are well deployed for the advantage of the society
(Kleindl, Burrow, & Dlabay, 2016). In the long run, a company under perfect competitive market
is in a position to achieve productive efficiency because the generation of goods and services
occurs at the lowest point of the average cost curve.
Figure 1: Productive efficiency under perfectly competitive firm
price and cost
Figure one above exhibits the long run situation of an enterprise functioning under
perfect competition market. Pe is the profit maximizing price whereas as Qe is the profit
maximizing output. It is clear that a perfectly competitive company is productive efficient
MC AC
0
P=MR=ARPe
H
QuantityQe

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because the generation of products happens at the lowest point of the average cost curve, that is,
point H, where the marginal cost matches the average cost.
Allocative Efficiency
When allocative efficiency takes place, it is a signal that the point selected on the
Production Possibility Curve is socially desirable. Further, this type of efficiency demonstrates
that the resources are apportioned to the creation of commodities that results in the best outcome
for the community. Under perfect competitive market, allocative efficiency occurs because
production happens at a point where the price equals the marginal cost (Deodhar, 2013).
Figure 2: Allocative efficiency under perfectly competitive firm
price and cost
P1 denotes the profit maximizing price while Q1 is profit maximizing production. A
perfectly competitive company operates at point F where the price matches the marginal cost,
that is, P=MC. This situation illustrates that allocative efficiency is attained and that resources
are allotted in the best interest of the community (Mankiw & Cosgrove, 2014).
AC
P=MR=ARP1
Q10 Quantity
MC
F

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Question 5
Inflation in Pakistan
Inflation denotes a sustained rise in the general prices in an economy (Hubbard, Garnett,
Lewis, & O'Brien, 2016). The type of inflation that Pakistan is encountering is referred to as
cost-push inflation. Cost-push inflation relates to a loss of the purchasing power of currency
resulting from an increase in the cost of production. Factors that disrupt supply like natural
disasters and a hike in the cost of production lead to a weak supply and hence cost-push inflation
(Goodwin, Nelson, & Harris, 2014).
Figure 3: Cost-push inflation
Price level
Real GDP (Y)
SRAS1 is the initial aggregate supply curve where the real Gross Domestic Product is
denoted by Y2 while the price is P1. Now when the supply is disrupted due to increase in the
cost of production or on the occurrence of a natural disaster, the supply will reduce. A reduction
AD
SRAS 2
SRAS 1
Y1 Y2
P2
P1

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in the supply is illustrated by the shift in the aggregate supply curve from SRAS 1 to SRAS 2.
With aggregate demand remaining unchanged, this change in the aggregate supply results in a
decline in the real Gross Domestic Product and a rise in price level (Mankiw N. G., 2014). The
output moves from Y2 to Y1 whereas the price from P1 to P2 as demonstrated on figure three
above.
The Sources of Cost-Push Inflation in Pakistan in 2010
Natural Disaster
A natural disaster is one of the factors that disrupt the production of goods in an
economy. In 2010, a significant portion of Pakistan was hit by massive floods that resulted in the
enormous destruction of the crop, infrastructure, and livestock. This event caused a sharp rise in
commodity prices as well as a spike in inflation. For example, the price of food items like meat,
pulses, rice, edible oil, vegetable, and sugar increased significantly (Hanif, 2012).
Increase in the Price of Raw Materials
The price of inputs used in the generation of goods and services play a significant role in
determining the general prices in an economy. When the price of raw material increases, the
producers scales back their production resulting in shortages and finally surging prices.
Furthermore, as businesses decisions are geared towards profit maximization, they tend to pass
the extra cost associated with production to the consumers by pricing their commodities highly
(Nils Gottfries; Palgrave Macmillan., 2013). In 2010, the rise in the price of raw material such as
fertilizer and cotton caused cost-push inflation in Pakistan. The floods also resulted in shortages
of inputs and hence higher prices (Asghar & Naveed, 2015).

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Surging Oil Prices
The demand for oil is known to be inelastic. As a result, a rise in the price of oil is
favorable to the exporters because their incomes will grow significantly. However, the oil
importers are the one who carries the burden connected to soaring prices. The prices of oil
indirectly affect costs like transportation, heating, and manufacturing (Frank & Bernanke, 2011).
Pakistan businesses experienced a rise in the cost of production due to higher prices in the global
market. Increase in the price of gas, petrol, diesel, compressed natural gas (CNG), as well as
power tariff rates caused higher production and freight costs and thus the acceleration of
inflation. Furthermore, structural issues such as weaknesses in supply chains and power outages
were detrimental to production performance in the economy and hence a rise in the general
prices (Asghar & Naveed, 2015).
Changes in Fiscal Policy
Variations in the fiscal instruments can also disrupt supply in an economy and thus result
in a drop in aggregate supply. For example, when the government increases or introduces new
taxes on producers, the cost of production will rise and hence a surge in the general prices
(McTaggart, Findlay, & Parkin, 2015). In Pakistan, the government eliminated energy subsidies.
Initially, the subsidies were meant to cushion the producers against higher production costs
associated with the acquisition of fuel (Asghar & Naveed, 2015). Therefore, the elimination of
the subsidies increased the cost of production leading to a drop in the aggregate supply and
consequently cost-push inflation.

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Question 4
The Economy of Germany
Aggregate Demand
The aggregate demand incorporates the entire demand for services and goods generated
in an economy. Changes in the total demand result from variation in consumer expenditure, net
exports, investment expenditure as well as government spending (Case, Fair, & Oster, 2014).
The total demand, along with the aggregate supply, plays a crucial role in determining a
country’s Gross Domestic Product, unemployment rate, and inflation levels.
Fall in the Demand for Germany’s Exports
Export earning is one of the components that influence the aggregate demand (Case, Fair,
& Oster, 2014). Therefore, a decline in the demand for Germany’s exports in the international
market will result in a decrease in the total demand. On figure four below, a scale back in the
total demand is depicted by a leftward shift in the total demand curve from AD1 to AD0.
Consequently, the economic growth will slow down. On the graph below, this scenario is
demonstrated by the change in the real Gross Domestic Product from Y2 to Y2.

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Figure 4: A Decline in the aggregate demand
Price level
Real GDP (Y)
Unemployment Level
Unemployment refers to a scenario where able and willing to work people fails to get a
job at the prevailing wage rate (Tucker, 2016). When Germany’s exports decline, the aggregate
demand will also drop increasing unemployment. The type of unemployment that takes place
when there is insufficient aggregate demand is known as demand deficient unemployment. When
the demand deteriorates, the companies sell less and thus cut their production. As a result, the
demand for employees will decline (Case, Fair, & Oster, 2014). Moreover, in severe situations,
some firms will fire their staff while others freeze hiring.
Inflation
AS
P2
P1
AD 1
AD 0
Y1 Y2

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Inflation incorporates a sustained increment in the general prices in an economy
(Hubbard, Garnett, Lewis, & O'Brien, 2016). A drop in Germany’s aggregate demand due to
weak exports will result in a decrease in the general prices. On graph four above, as the
aggregate demand curve shifts from AD1 to AD0, the general prices decline from P2 to P1.
The Aggregate Supply
Aggregate supply includes total products generated in an economy at a particular time. A
decline in Germany’s export demand will make the companies reduce their production. This
move results in a drop in the aggregate supply. Also, with reduced earnings, the companies will
not be in a position to raise the wages of workers. In some instances, the firms may decide to hire
employees on contracts and thus eliminate the benefits they could receive when they are
permanently employed. If such situations act as a discouragement to workers, then we anticipate
their productivity to deteriorate. Diminishing productivity will result in low production and
hence a drop in the aggregate supply and slowdown in economic growth and development
(McTaggart, Findlay, & Parkin, 2015).
Figure 5: A Decrease in the aggregate supply
Price level
AD
SRAS 2
SRAS 1
P2
P1

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Real GDP (Y)
The decline in the aggregate supply is displayed by the shift of the aggregate supply
curve leftward from SRAS1 to SRAS2. Consequently, the real Gross Domestic Product will drop
from Y2 to Y1. The general prices in the economy will rise from P1 to P2 resulting in cost-push
inflation. Therefore, the intervention of the government in an economy when the aggregate
demand is insufficient plays a significant role in stabilizing the economy.
Y1 Y2

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