Page 47 - DECO201_MACRO_ECONOMICS_ENGLISH

Macro Economics

Notes Figure 3.4
Y
S
Real L
wage

E
1
E
2
D
L
1
D
L
2
O L Qty of Lab. X

Figure 3.5
Y
S
Real L
wage

E
2

E
1
D
L 2
D
L
1
O L Qty of Lab. X

3.2.2 Product Market Equilibrium

The product market equilibrium is attained at that 'overall price level' at which Aggregate
Demand (AD) equals Aggregate Supply (AS). What is the behaviour of AD and AS with respect
to price level?

Let us first take AS. In the classical scheme of things, AS has nothing to do with price level. How
is AS determined? Labour market is in equilibrium at the full employment of labour (Figure
3.2). Given full employment of labour, the production function determines full employment
level of output. Refer to the figure 3.6. The TP curve represents the production function of the
variable input labour. Note that it is concave throughout because it is based on the assumption
that the Law of Diminishing Returns is operating from the very beginning. (There is no increasing
returns to a variable factor). It means that TP increases at a decreasing rate until it reaches
maximum.

Given OL , the full employment quantity of labour, the total output produced by OL is OY . This
f f f
is the potential GDP at full employment of labour, also called 'aggregate supply'.

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