IB Economics - Aggregate Supply

This study note for IB economics covers Aggregate Supply

1. Understanding Aggregate Supply

Definition:

• Aggregate Supply (AS) represents the total quantity of goods and services that firms in an economy are willing and able to produce at a given overall price level in a given period.

Key Points:

• Aggregate Supply is essential for understanding the overall productive capacity of an economy.
• It reflects the relationship between the overall price level and the total output of goods and services produced in the economy.

2. Short-Run Aggregate Supply (SRAS) Curve

Definition:

• The Short-Run Aggregate Supply (SRAS) curve shows the relationship between the total quantity of goods and services that firms are willing to produce and the price level in the short run.

Diagram and Explanation:

• Diagram: The SRAS curve is upward sloping. On the horizontal axis, we have the Real GDP, and on the vertical axis, we have the Price Level.
• Why is it upward sloping?
  • Sticky Wages: In the short run, wages and some prices are sticky (slow to adjust). When the price level rises, firms experience higher revenue but their costs (wages) don’t immediately increase, so they produce more.
  • Menu Costs: Higher prices can lead to firms adjusting their output as they can charge more without immediately facing higher costs.
  • Profit Margins: As the price level rises, profit margins improve if wages and other input costs remain unchanged, encouraging firms to increase output.

Real-World Example:

• During periods of economic expansion, such as the U.S. recovery post-2008 financial crisis, businesses faced rising prices and increasing demand, leading to a shift along the SRAS curve as firms increased production.

3. Shifts in the SRAS Curve

Factors Causing Shifts:

1. Changes in Resource Prices:
   • Decrease in Resource Prices: Lowers production costs, shifting SRAS to the right. Example: Falling oil prices reduce transportation and production costs.
   • Increase in Resource Prices: Raises production costs, shifting SRAS to the left. Example: Rising wages or higher raw material costs.
2. Changes in Business Taxes and Subsidies:
   • Increase in Taxes: Reduces profit margins, shifting SRAS to the left. Example: Increased corporate tax rates can reduce firms' ability to produce.
   • Increase in Subsidies: Lowers production costs, shifting SRAS to the right. Example: Government subsidies for renewable energy.
3. Supply Shocks:
   • Positive Supply Shock: Unexpected events that increase productivity or reduce costs, shifting SRAS to the right. Example: Technological advancements.
   • Negative Supply Shock: Unexpected events that increase costs, shifting SRAS to the left. Example: Natural disasters disrupting supply chains.

4. Alternative Views of Aggregate Supply

Monetarist/New Classical Model (Long-Run Aggregate Supply - LRAS):

Definition:

• The LRAS curve is vertical at the level of potential output (full employment output) because, in the long run, aggregate supply is determined by factors such as technology and resources, not by the price level.

Diagram and Explanation:

• Explanation: In the long run, the economy adjusts to the potential output regardless of the price level. This is because any changes in the price level do not affect the real output; instead, they affect only the nominal prices and wages.

Keynesian Model (Three Sections of AS Curve):

Definition:

• The Keynesian AS curve is characterised by three distinct segments reflecting different levels of economic activity and price flexibility.

Diagram and Explanation:

• Section 1: Horizontal segment where output can increase without a change in price level due to significant spare capacity (recession).
• Section 2: Upward-sloping segment reflecting increased costs as the economy approaches full capacity (middle range of output).
• Section 3: Vertical segment at full employment output, where any increase in demand leads to higher prices rather than increased output (overheating economy).

Real-World Example:

• During the Great Depression, the Keynesian model’s horizontal segment illustrates the economy's capacity to increase output without inflation due to high unemployment.

5. Shifting the Aggregate Supply Curve Over the Long Term

Monetarist/New Classical Model:

• Factors Affecting Long-Term AS:
  • Improvement in Efficiency: Enhanced productivity shifts LRAS to the right. Example: Advances in technology.
  • New Technology: Innovations increase potential output. Example: The digital revolution.
  • Reductions in Unemployment: More effective use of labor shifts LRAS to the right. Example: Policy changes leading to lower structural unemployment.
  • Institutional Changes: Reforms that improve market efficiency. Example: Deregulation.

Keynesian Model:

• Factors Leading to Long-Term Shifts:
  • Similar to Monetarist Factors: Improvements in technology, efficiency, and labor market reforms shift the aggregate supply curve to the right in the long term.

Real-World Example:

• The increase in the U.S. LRAS during the 1990s tech boom reflects long-term shifts due to technological advancements and productivity improvements.

Glossary

• Aggregate Supply (AS): The total output of goods and services that firms are willing and able to produce at a given price level.
• Short-Run Aggregate Supply (SRAS): The AS curve that shows the relationship between the total quantity of goods and services firms are willing to produce and the price level in the short run.
• Long-Run Aggregate Supply (LRAS): The AS curve in the long run, which is vertical at the level of potential output.
• Potential Output: The maximum amount of goods and services an economy can produce when operating at full efficiency.
• Sticky Wages: Wages that are slow to adjust to changes in economic conditions.
• Supply Shock: An unexpected event that changes the cost of production or availability of goods and services.

IB Economics Essay-Style Questions

1. Discuss the factors that can lead to shifts in the Short-Run Aggregate Supply curve and analyze their potential impacts on the economy.
2. Compare and contrast the Monetarist and Keynesian views of Long-Run Aggregate Supply. How do these models explain changes in potential output?
3. Explain how changes in resource prices and business taxes can affect the Short-Run Aggregate Supply curve using real-world examples.
4. Evaluate the role of technological advancements in shifting the Long-Run Aggregate Supply curve. Provide examples from recent economic history.

Suggested Economists for Further Reading

• Milton Friedman: Known for his work on the Monetarist perspective of aggregate supply.
• John Maynard Keynes: Foundational work on Keynesian economics and aggregate supply.
• Robert Lucas: Contributions to the New Classical view on aggregate supply and economic policy.

Real-World Data Example

• U.S. Oil Price Shock: The 2008 surge in oil prices led to a negative supply shock, shifting the SRAS curve leftward and increasing inflationary pressures.

Retrieval Questions for A-Level Students

1. What does the Short-Run Aggregate Supply curve represent?
2. Why is the SRAS curve upward sloping in the short run?
3. How can changes in resource prices affect the SRAS curve?
4. What effect do business taxes have on the SRAS curve?
5. Explain the concept of a supply shock and its impact on the SRAS curve.
6. What does the Monetarist view suggest about the LRAS curve?
7. Describe the three sections of the Keynesian Aggregate Supply curve.
8. How do improvements in technology influence the LRAS curve?
9. What is meant by 'sticky wages' and how does it affect the SRAS curve?
10. How does the Keynesian model explain changes in aggregate supply during a recession?