Economics 2.3 Aggregate Supply

What is Aggregate Supply (AS)?

Aggregate supply is the total volume of goods and services produced within an economy at a given price level. It shows the relationship between real GDP and the average price level.

What does the short-run Aggregate Supply (AS) curve represent?

The short-run AS curve shows the quantity of goods and services firms are willing to supply at different price levels when some factors, like wages and technology, are fixed.

Why is the short-run AS curve upward sloping?

Because firms will supply more output only at higher prices due to rising costs like overtime pay and incentives for extra work, which increases production costs and prices.

How do firms increase production in the short run?

Firms increase production by making current employees work overtime, working harder, or hiring temporary workers, rather than hiring permanent staff.

Why might firms avoid hiring additional full-time permanent staff in the short run?

Because they risk having to lay them off if demand falls later, which could damage their reputation and be costly due to redundancy payments.

How do firms incentivize employees to work overtime or harder?

They offer bonuses or pay overtime rates, such as one and a half times the basic wage rate.

What happens to the average and marginal cost of labor per good when firms increase production in the short run?

Both average and marginal costs increase because firms pay more in wages per good produced (due to overtime or incentives).

How does an increase in production costs affect prices?

Firms pass on higher labor costs to consumers through increased prices, contributing to a higher overall price level.

What does it mean that short-run AS is elastic?

It means output changes by a larger percentage than the price change; firms are responsive to price changes in the short run.

Why do prices only rise relatively little in the short run when output increases?

Because factor prices (like wages) are fixed in the short run, so cost increases are limited.

What happens to prices if demand falls in the short run?

Firms try to reduce prices to stimulate demand, but they can't cut prices much due to fixed factor prices and reluctance to lay off workers.

What causes movement along the AS curve?

Changes in the price level cause movement along the curve (expansion or contraction of output supplied).

What causes the AS curve to shift?

Factors other than price changes, such as changes in wages, technology, or production costs, cause the AS curve to shift.

What is the difference between short-run and long-run in terms of factor inputs?

Short run: at least one factor of production is fixed (e.g., wages, technology).
Long run: all factors of production are variable.

In the short run, which variables are fixed on the AS curve?

Money wage rates, factor prices, and technology are fixed.

What happens if money wage rates, factor prices, or technology change?

The AS curve shifts (either left or right) depending on whether these changes increase or decrease production costs or productivity.

Is there consensus among economists on the shape of the long-run Aggregate Supply (LRAS) curve?

No, there is disagreement about the exact shape of the LRAS curve.

What is the main cause of a shift in the Short-Run Aggregate Supply (SRAS) curve?

A change in the cost of production is the main cause of a shift in the SRAS curve.

How do changes in the cost of raw materials and energy affect the SRAS curve?

An increase in raw material and energy costs raises production costs, shifting the SRAS curve to the left because businesses produce the same output only if prices rise.

Why are oil prices particularly important for SRAS?

Because oil affects production costs for almost all businesses, changes in oil prices significantly impact the overall SRAS.

How do changes in exchange rates influence SRAS?

A weaker pound makes imports more expensive, increasing production costs and shifting SRAS left. A stronger pound makes imports cheaper, reducing costs and shifting SRAS right.

Why is the exchange rate especially important for the UK’s SRAS?

The UK is heavily dependent on imports, so fluctuations in the pound directly affect production costs and the SRAS curve.

How did the fall in the pound after Brexit affect SRAS in the UK?

The fall in the pound increased import prices, pushing up production costs and causing cost-push inflation, which shifted SRAS left.

What impact do changes in tax rates have on the SRAS curve?

Higher taxes increase production costs, shifting SRAS to the left, while subsidies reduce costs and shift SRAS to the right.

What are supply-side shocks?

Significant changes in costs of raw materials, energy, exchange rates, or taxes that cause sudden shifts in the SRAS curve.

How does supply increase differ between the short run and long run?

In the short run, supply can be increased by overtime or using existing resources more intensively, but in the long run, supply is limited by the availability of labor, machines, and maximum labor productivity.

What is different about wage rates on the LRAS curve compared to the SRAS curve?

On the LRAS curve, wage rates and factor prices are variable and can change, unlike in the short run where they are fixed.

What does the classical view say about the shape of the LRAS curve?

The classical LRAS curve is vertical, meaning long-run aggregate supply is independent of the price level and determined by factors of production and technology.

What does the vertical LRAS curve represent in the classical model?

It represents the economy’s full productive potential where all resources are fully employed, linked to the production possibility frontier (PPF).

Why can the economy temporarily exceed its potential output in the short run?

Firms can make factors of production work overtime or delay maintenance, increasing output beyond sustainable levels, but this is not possible in the long run.

What is the classical view about market equilibrium and LRAS?

Markets tend to self-correct quickly, so the economy moves toward full employment and productive potential (equilibrium) on the vertical LRAS curve.

How did Keynes challenge the classical view of the LRAS curve?

Keynes argued the economy can be in disequilibrium for decades, so the LRAS curve cannot be strictly vertical; it may have a different shape reflecting unemployment and wage rigidity.

Describe Keynes’s LRAS curve shape.

Keynes’s LRAS has three parts: a horizontal section at low output (high unemployment), an upward-sloping section (wages rise with employment), and a vertical section at full employment (productive potential).

What does the horizontal section of Keynes’s LRAS represent?

It represents a range where unemployment is high, wages are sticky downward, and firms can hire workers without raising wages, so output can increase without price rises.

Why are wages "sticky downwards" according to Keynes?

Because unions prevent wage cuts, businesses want to keep worker motivation, workers won’t work below certain wages, labor mobility issues exist, and minimum wage laws prevent wages falling too low.

What happens between points A and B on Keynes’s LRAS curve?

Employment rises, labor becomes scarcer, firms must offer higher wages to attract workers, increasing costs and prices, so output becomes less price elastic.

What happens at point B on Keynes’s LRAS curve?

The economy reaches full productive capacity (PPF), LRAS becomes vertical, and increases in price level no longer increase output.

What does a rightward shift of the LRAS curve represent?

It means the economy can produce more goods and services, equivalent to an outward shift of the Production Possibility Frontier (PPF).

What generally causes shifts in the LRAS curve?

Increasing productivity (producing more goods with the same resources) or increasing the quantity of resources available.

How do technological advances affect LRAS?

They shift LRAS right by speeding up production, allowing more goods to be produced with the same resources.

Why does investment in technology increase LRAS?

More machines and better technology mean increased production capacity and efficiency.

How does relative productivity influence LRAS?

Higher productivity means more output with the same resources, encouraging production and investment, which shifts LRAS right.

What role do education and skills play in shifting LRAS?

A more skilled workforce is more efficient, increasing output per worker and shifting LRAS right; also improves occupational mobility, reducing structural unemployment.

How can government regulations impact LRAS?

• Encouraging workforce growth (e.g., childcare, reducing benefits, changing working age) increases resources, shifting LRAS right.

• Offering tax breaks for research and development promotes innovation, increasing LRAS.

• Making business setup easier and lowering corporation tax encourages entrepreneurship, boosting LRAS.

• High regulation can limit LRAS by increasing costs and reducing efficiency.

How do demographic changes and migration affect LRAS?

• Immigration exceeding emigration grows the working population, increasing LRAS.

• The impact depends on immigrants’ age and skills.

• An ageing or very young population lowers LRAS due to fewer working-age people.

How does competition policy influence LRAS?

Promoting competition forces businesses to improve efficiency and quality, increasing LRAS. However, some less competition (e.g., via copyright) can encourage innovation and investment, also raising LRAS.

What are supply-side shocks in the context of LRAS?

Large, sudden changes like technological breakthroughs or wars that significantly shift LRAS.