Question

While the adaptive expectations approach is valid, obtain the short-term and long-term total supply curves according to the fact that the general level of prices decreases from P1 to P2.

Answer 1

Adaptive Expectation-Short run & Long run

The hypothesis of adaptive expectations in economics states how individuals make expectation to future activities based on the recent past experiences they have. The theory suggests people will make economic decisions even regarding investments etc. analyzing the performance of economy including stock markets, inflation rates etc. Recent market movements have serious effects in the economic activities of upcoming future and decisions on that by individuals.

A reduction in price will reduce the supply level in the short run under adaptive expectations. Producers think the recent performance impact makes an effect on the upcoming period due to the reduction in prices; the level of supply will be reduced to manage the reduction in the revenue due to reduced per unit revenue. The supply curve will shift downwards showing the reduced level of supply. Also, the long run supply curve will be a vertical line showing no change in the level of supply due to a change in the price. The long run effect is because of the various fluctuations in short run and gaining the level of supply to the optimum level. The reduction in supply increase the price and thus gaining back the old level of supply.

The short run supply curve will shifts downwards to left after a reduction in price. The long run curve will be a vertical line with no effects of supply over price.