2.3.1 Characteristics of Aggregate Supply (AS)

This study note for Edexcel covers characteristics ofAggregate Supply

1. The AS Curve

• Definition: The Aggregate Supply (AS) curve represents the total quantity of goods and services that producers in an economy are willing and able to supply at different price levels, ceteris paribus.
• Shape:
  • In the short run (SRAS), the AS curve is upward sloping because:
    • Prices of inputs (like wages) are sticky and do not adjust immediately to changes in the price level.
    • Higher prices can temporarily increase profit margins, leading firms to increase production.
  • In the long run (LRAS), the AS curve is vertical at the full-employment level of output (potential GDP) because:
    • In the long run, all prices, including wages, are flexible.
    • Output is determined by factors such as technology, resources, and institutions, not by the price level.

2. Movement Along vs. Shift of the AS Curve

• Movement Along the AS Curve:
  • Caused by a change in the price level.
  • Example: If the price level rises, we move up along the SRAS curve, indicating an increase in the quantity of goods and services supplied.
  • Real-World Example: During a demand-pull inflation scenario, higher demand raises the price level, and firms respond by increasing production, moving up the SRAS curve.
• Shift of the AS Curve:
  • Caused by changes in non-price level factors affecting supply.
  • SRAS Shifts:
    • Rightward Shift: Indicates an increase in aggregate supply. Causes include reductions in production costs, technological advancements, or improvements in productivity.
    • Leftward Shift: Indicates a decrease in aggregate supply. Causes include increases in production costs, supply shocks (e.g., natural disasters), or reduced productivity.
  • LRAS Shifts:
    • Rightward Shift: Reflects long-term economic growth, such as increased capital stock, technological progress, or an increase in the labor force.
    • Leftward Shift: Reflects a decrease in an economy's productive capacity, such as due to destruction of capital or a decrease in the labor force.
  • Real-World Example: The COVID-19 pandemic caused a leftward shift in SRAS due to disrupted supply chains and labor market constraints.

3. Relationship Between Short-Run AS and Long-Run AS

• Short-Run AS (SRAS):
  • Prices of some inputs (like wages) are sticky and do not adjust immediately.
  • Firms respond to higher prices by increasing output since they have higher profit margins.
  • SRAS can be influenced by temporary factors like changes in production costs or expectations.
• Long-Run AS (LRAS):
  • All input prices are flexible, and the economy is at full employment.
  • Reflects the economy's maximum sustainable output, given its resources and technology.
  • Determined by factors like labor force size, capital stock, and technological innovation.
• Connection:
  • In the short run, deviations from full employment can occur, causing the SRAS to shift.
  • In the long run, the economy adjusts to its potential output level, reflected by a vertical LRAS curve.

Key Economists and Contributions

• John Maynard Keynes:
  • Emphasized the role of aggregate demand in influencing economic output and employment.
  • Introduced the concept of price stickiness, which underpins the upward slope of the SRAS curve.
• Milton Friedman:
  • Highlighted the importance of expectations in the adjustment of prices and wages.
  • His work on the natural rate of unemployment influences the understanding of the LRAS curve.
• Robert Lucas:
  • Developed the theory of rational expectations, impacting how shifts in AS are perceived.
  • Emphasized the importance of policy credibility and expectations in economic outcomes.

Glossary

• Aggregate Supply (AS): The total quantity of goods and services that producers in an economy are willing and able to supply at different price levels.
• SRAS Curve: Short-Run Aggregate Supply curve; shows the relationship between the price level and the quantity of goods and services supplied in the short run.
• LRAS Curve: Long-Run Aggregate Supply curve; represents the economy's potential output at full employment, unaffected by the price level.
• Price Stickiness: The resistance of prices, especially wages, to change quickly despite changes in demand or supply conditions.
• Supply Shock: An unexpected event that suddenly changes the supply of a good or service, leading to sudden price changes.
• Potential GDP: The level of output that an economy can produce at a constant inflation rate when utilizing all its resources efficiently.

Possible Essay-Style Questions

1. Explain the factors that can cause a shift in the Short-Run Aggregate Supply curve. Provide real-world examples to support your explanation.
2. Discuss the relationship between the Short-Run and Long-Run Aggregate Supply curves. How do economies transition from short-run to long-run equilibrium?
3. Analyze the impact of technological advancements on the Aggregate Supply curves. What are the implications for long-term economic growth?
4. Evaluate the effects of supply shocks on the aggregate economy. How should policymakers respond to negative supply shocks to stabilize the economy?
5. Compare and contrast the views of Keynes and Friedman on the determinants of Aggregate Supply. How do their perspectives inform modern economic policy?