How Demand Determines Output in the Short Run

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HOW DEMAND DETERMINES OUTPUT IN THE SHORT RUN

Typically, firms that supply intermediate goods such as steel rods or other inputs let demand not price determine the level of output in the short run. To understand this idea, consider an automobile firm that buys material from a steelmaker on a regular basis. Because the auto firm and the steel producer have been in business with one another for a long time and have an ongoing relationship, they have negotiated a contract that keeps steel prices fixed in the short run. But suppose the automobile company’s cars suddenly become very popular. The firm needs to expand production, so it needs more steel. Under the agreement made earlier by the two firms, the steel company would meet this higher demand and sell more steel without raising its price to the automobile company. As a result, the production of steel is totally determined in the short run by the demand from automobile producers, not by price. But what if the firm discovered that it had produced an unpopular car and needed to cut back on its planned production? The firm would require less steel. Under the agreement, the steelmaker would supply less steel but not reduce its price. Again, demand not price determines steel production in the short run. Similar agreements between firms, both formal and informal, exist throughout the economy. Typically, in the short run, firms will meet changes in the demand for their products by adjusting production with only small changes in the prices they charge their customers.

What we have just illustrated for an input such as steel applies to workers, too, who are also inputs to production. Suppose the automobile firm hires union workers under a contract that fixes their wages for a specific period. If the economy suddenly thrives at some point during that period, the automobile company will employ all the workers and perhaps require some to work overtime. If the economy stagnates at some point during that period, the firm

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