Describe what happens when firms and workers underestimate future prices in the economy. Focus your answer on what would happen to actual output as opposed to the expected potential output. please refer to info below.

Potential output

The wage rate that is paid by firms to workers is based on the expected price level in the economy in the future. If firms and workers expect prices to increase by 4% over the next year, an agreement on a 5% increase in wages may be reached. If the price level in the economy ends up as expected by the end of the year, there are no surprises. This results in the economy operating at its potential output. As McEachern (2019) states, think of thepotential outputas the economy's maximum sustainable output, given that the amount of resources on hand, the level of technology, and the current rules of the game are as expected.

Problems can arise when there are surprises in the economy. For instance, if the price level in the economy is lower than expected, firms will lose money. These firms negotiated a wage rate based on the expectation of higher prices. Lower prices would mean lower revenues while labor costs would continue to be high.

The opposite would be true if prices were higher than expected. The firm would experience higher profits than expected because wage rates would remain the same, but the selling price for output would be higher. In this case, firms have the incentive to increase production beyond potential output. Firms could pay higher wages for overtime or hire more unemployed labor to capture these unexpected profits.