When looking at output and costs, the positive slope of the aggregate supply curve shows us how costs and prices are related to output. The aggregate supply curve compares price level to the quantity of output that firms produce and sell, assuming that technology and prices of the factors of production are constant.
In theory, as output increases, less efficient plants and workers will have to be employed, as well as existing workers paid overtime for additional work. This makes unit costs (the cost per unit of output) increase, even when input prices and technology are still constant.
If unit costs increase with output, price-taking firms will produce more if price increases, and less if the price falls. If the demand for the output of price-setting firms increases enough to take their outputs into the range where unit costs rise, these firms will not increase outputs until they pass at least some of the extra costs on through higher prices¹. When demand falls, they will reduce output and competition will cause a reduction in price when unit costs fall.
Price setting firms will raise prices when they expand their output into the range where unit costs rise¹. Eventually, firms will decrease their prices if a reduction in output leads to a reduction in unit costs¹.
The actions of price-taking and price-setting firms cause the price level and supply of output to be positively related – the aggregate supply (AS) curve is positively sloped¹. On an aggregate supply graph, the aggregate supply curve is positively sloped, showing that firms will produce more aggregate output only at a higher price level.
1. Ragan, Chrisopher. Macroeconomics/Christopher T.S. Ragan, Richard G. Lipsey. – 13th Canadian ed.