Understanding how quickly input prices adjust is essential for interpreting short-run fluctuations versus long-run outcomes. This time-horizon distinction explains why output and employment can deviate temporarily from potential but not permanently.

The core distinction: which prices can change?

Inputs, wages, and prices

• Input prices are the costs firms pay for resources used to produce output (especially wages, but also rents, energy, and some contracted materials).

• The key idea is timing:

  • In the short run, at least some important input prices are fixed.

  • In the long run, wages and prices are fully flexible and can adjust to economic conditions.

Because some costs are “stuck,” firms may respond to changes in demand by changing output and employment rather than instantly changing all prices and wages.

Two side-by-side supply-and-demand panels showing how a leftward shift in demand creates excess supply when wages (in the labor market) or prices (in the goods market) are temporarily sticky. The figure links nominal rigidity to real outcomes—lower quantities traded—helping explain why output and employment can fall in the short run even before wages and prices fully adjust. Source

Why some input prices are fixed in the short run

Sticky (slow-adjusting) input prices commonly arise from:

• Wage contracts (multi-month or multi-year agreements)

• Implicit contracts (firms avoid frequent wage changes to maintain morale and retain workers)

• Menu costs and coordination problems (it can be costly or difficult to change many prices at once)

• Expectations and information lags (decision-makers may wait for clarity before renegotiating)

A “long run” is not a fixed number of months; it depends on how quickly contracts reset and how rapidly markets and expectations adjust.

What “fixed” versus “flexible” implies for the economy

An AD–AS diagram showing a vertical long-run aggregate supply (LRAS) at potential output and an upward-sloping short-run aggregate supply (SRAS). Movements of aggregate demand can shift equilibrium along SRAS in the short run (changing real GDP and the price level), while the long run is characterized by output returning to potential as wages and prices fully adjust. Source

Short run: quantity adjustments are larger

When some input prices are fixed:

• If the overall price level rises while wages are temporarily fixed, firms’ real labour cost can fall, making it more profitable to hire and produce more.

• If the price level falls while wages are fixed, firms’ real costs can rise, causing cutbacks in production and employment.

• As a result, the economy can experience:

  • Recessions (lower output, higher unemployment) or

  • Booms (higher output, lower unemployment) even without any immediate, economy-wide wage adjustment.

Long run: price and wage adjustments restore consistency

When wages and prices are fully flexible:

• Workers and firms renegotiate nominal wages to reflect labour market conditions and the price level.

• Input costs adjust, so firms’ profitability is less likely to depend on temporary mismatches between output prices and input prices.

• The economy’s real variables (like real output and employment) are driven mainly by:

  • technology, resources, and institutions rather than by the price level itself.

How to use the time horizon correctly in AP analysis

Interpreting “short run” statements

In short-run reasoning, emphasise:

• Sticky wages/prices (some costs fixed)

• Firms responding to changed conditions by altering output and employment

• Temporary departures from what the economy can sustain with fully adjusted wages and prices

Interpreting “long run” statements

In long-run reasoning, emphasise:

• Full flexibility of wages and prices

• Adjustment of nominal variables to new conditions

• The idea that persistent changes in real output require changes in productive capacity, not just changes in the price level