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AS Macroeconomics / International Economy

Aggregate Supply

Having looked at the components of aggregate demand, we now turn to the supply-side of the economy. Aggregate supply tells us something about whether producers across the economy can supply us with the goods and services that we need.

A definition of aggregate supply

Aggregate supply (AS) measures the volume of goods and services produced within the economy at a given price level. In simple terms, aggregate supply represents the ability of an economy to produce goods and services either in the short-term or in the long-term. It tells us the quantity of real GDP that will be supplied at various price levels. The nature of this relationship will differ between the long run and the short run

• In the long run, the aggregate-supply curve is assumed to be vertical
• In the short run, the aggregate-supply curve is assumed to be upward sloping

Short run aggregate supply (SRAS) shows total planned output when prices in the economy can change but the prices and productivity of all factor inputs e.g. wage rates and the state of technology are assumed to be held constant.

Long run aggregate supply (LRAS):  LRAS shows total planned output when both prices and average wage rates can change – it is a measure of a country’s potential output and the concept is linked strongly to that of the production possibility frontier

The short run aggregate supply curve

A change in the price level (for example brought about by a shift in AD) results in a movement along the short run aggregate supply curve. The slope of SRAS curve depends on the degree of spare (under-utilised) capacity within the economy.

• Negative output gap: At low levels of real national income where actual GDP < potential GDP, firms have a large amount of spare capacity and can expand their output without paying their workers overtime. The SRAS curve is therefore drawn as elastic
• Positive output gap: As national output expands and the economy heads towards full capacity, so “supply bottlenecks and shortages” may start to appear in some sectors and industries. Workers receive the same wage rate but require payment of overtime and bonuses to work longer hours and increase GDP – SRAS is becoming more inelastic
• Diminishing returns? As national output expands, older less productive machinery may be used and less efficient workers hired. This means that while wage rates remain constant, unit costs of production may rise and thus the SRAS slopes upwards
• Full-capacity output at LRAS. Eventually the economy cannot increase the volume of output further in the short-term no matter what bonus or overtime payments on offer, at this point SRAS is perfectly inelastic – the economy has reached full-capacity (the LRAS curve)

Shifts in short run aggregate supply (SRAS)

Shifts in the SRAS curve can be caused by the following factors

• Changes in unit labour costs: Unit labour costs are defined as wage costs adjusted for the level of productivity. For example a rise in unit labour costs might be brought about by firms agreeing to pay higher wages or a fall in the level of worker productivity. If unit wage costs rise, this will eventually feed through into higher prices (this is known as an example of “cost-push inflation”)

• Commodity prices: Changes to raw material costs and other components e.g. the world price of oil, copper, aluminium and other inputs in many production processes will affect a firm’s costs. These costs might be affected by a change in the exchange rate which causes fluctuations in the prices of imported products. A fall (depreciation) in the exchange rate increases the costs of importing raw materials and component supplies from overseas
• Government taxation and subsidy: Changes to producer taxes and subsidies levied by the government as part of their fiscal policy have effects on the costs of nearly every producer – for example an increase in taxes designed to meet the government’s environmental objectives will cause higher costs and an inward shift in the short run aggregate supply curve. A rise in VAT on raw materials will have the same effect.

The short run aggregate supply curve is upward sloping because higher prices for goods and services make output more profitable and enable businesses to expand their production by hiring less productive labour and other resources

Shifts in aggregate supply in the short run

Shifts in the short run aggregate supply curve are illustrated in the diagram below

The most important single cause of a shift in the short run aggregate supply curve is a change in wage rates. Higher wage rates without any compensating increase in labour productivity cause a rise in production costs, leading businesses to produce less and the aggregate supply curve will shift to the left (i.e. SRAS1 shifts to SRAS2). Conversely a fall in raw material prices or component costs will reduce production costs, encouraging firms to produce more and the short run aggregate supply curve moves to the right (i.e. SRAS1 shifts to SRAS3).

Long run aggregate supply (LRAS)

In the long run, the ability of an economy to produce goods and services to meet demand is based on the state of production technology and the availability and quality of factor inputs.

A long run production function for a country is often written as follows:

Y*t = f (Lt, Kt, Mt)

• Y* is an aggregate measure of potential output in an economy
• T is the time period under consideration
• L represents the quantity and ability of labour input available to the production process
• K represents the available capital stock, i.e. machinery, buildings and infrastructure
• M represents the availability of natural resources and materials for production i.e. land

LRAS is determined by the stock of a country’s productive resources and also by the productivity of factor inputs (labour, land and capital). Changes in the state of technology also affect the potential level of real national output.

The vertical long run aggregate supply curve

In the long run we assume that aggregate supply is independent of the price level. As a result we draw the long run aggregate supply curve as vertical. In drawing the LRAS as vertical, we are saying that there is a maximum level of physical output that the economy can produce. Neo-classical economists view the LRAS curve as being perfectly inelastic at a level of output where actual GDP has achieved its potential. There will be no unused labour in that all those who are available for employment at the prevailing wage rate will be in employment – in other words, a full-employment level of national income has been reached. There will remain the problem of voluntary unemployment.

According to the neo-classical school of economics, real GDP will in the long run always return to the level at which all available labour resources have found employment.

Causes of shifts in the long run aggregate supply curve

Any change in the economy that alters the natural rate of growth of output (i.e. trend growth) shifts the long-run aggregate-supply curve.

Improvements in productivity and efficiency or an increase in the stock of capital and labour resources cause the LRAS curve to shift out. This is shown in the diagram below. The result is that a great volume of national output can be produced at any given price level.

The fundamentals of increasing long run aggregate supply

These all relate to the supply-side of the economy

• Expanding the labour supply - e.g. by improving incentives for people to search for and then accept new jobs as they become available. Government policies seek to expand the available labour supply by encouraging more people to join the labour force and become economically active. The UK government has also been encouraging an influx of migrant labour which has added to the supply of labour although it is also causing concern about some of the social and political effects.
• Increase the productivity of labour and capital – e.g. by investment in training of the labour force and improvements in the quality of management and human resource management
• Increase the occupational and geographical mobility of labour to reduce certain types of unemployment for example the level of structural unemployment which is caused by occupational immobility of labour. A reduction in structural unemployment will reduce the scale of unemployment and provide the economy with a great supply of available labour.
• Expand the capital stock – i.e. increase the level of capital investment and research and development spending by firms
• Increase business efficiency by promoting greater competition within and between markets
• Stimulate a faster pace of invention and innovation – this will hopefully in the long term promote lower production costs and also improvements in the dynamic efficiency of markets

Aggregate supply shocks

Aggregate supply shocks might occur when there is

• A sudden rise in oil prices or other essential inputs
• The invention and diffusion of a new production technology

The effects of supply-side shocks are normally to cause a shift in the short run aggregate supply curve. But there are also occasions when significant changes in production technologies or step-changes in the productivity of factors of production that were not expected, feed through into a shift in the long run aggregate supply curve.