aggregate supply

aggregate supply (AS)

the total amount of domestic goods and services supplied by businesses and the government, including both consumer goods and capital goods, in the economy at every give price level

• the sum of the supply curves of all the industries in the economy

SRAS

• there is a positive relationship between the price level and the amount of output that a country’s industries will supply

short run 

• defined as the period of time when the prices of the factors of production do not change

  • the price of labour - the wage rate - is fixed

  • an increase in output will be accompanied by an increase in average costs

    • in order to produce more, firms have to provide incentives to workers to produce a larger amount - most commonly done by paying overtime wages → which many be one and a half times the normal wage and so costs rise

    • industries will pass on this cost in the form of a higher price level

supply side shocks 

a change in any of the factors other than the price level will result in the SRAS curve

• factors that cause changes in the costs of production

sticky wages

in the short run

• there isa direct relationship between the price level and the level of output and employment.

• Falling prices lead to less output and less employment, while rising prices lead to more output and more employment.

•  When wages don't adjust quickly to changes in the economy, particularly during a recession (e.g. employers lay-off instead of cut pay).

what changes costs of production

• change in wage rates

• change in cost of raw materials

• change in the price of imports

• change in gov indirect taxes or subsidies

change in wage rates

• an increase in wages will result in an increase in the costs of production to firms and therefore a fall in aggregate supply

  • ex: the gov raises the legal minimum wage → it would increase labour costs

  • ex: labour unions negotiate higher wages for manufacturing workers, then this would also result in a fall in the SRAS

a change in the costs of raw materials

an increase in the price of significant, widely used, raw materials such as oil

a change in the price of imports

• if the capital or raw materials used by a country’s industries are imported, then a rise in import prices will increase the costs of production

  • this can occur due to changes in the exchange rate of a country’s currency

change in gov indirect taxes or subsidies

• an increase in indirect taxes effectively increases the costs of production to firms and therefore results in a fall in the SRAS curve

• since subsidies are payment from gov to firms, then an increase in gov subsides reduce firms’ costs of production, resulting in an decrease in an increase in the SRAS

• indirect tax increases has more of an effect than subsidies

AD meets SRAS in short run 

the economy will operate where aggregate demand is equal to aggregate supply (market equilibrium) 

• at the average price level (PL), all the output produced by the country’s producers is consumed. there is no incentive for producers either to increase output or raise prices

long run aggregate supply

the long run is the period of time in which wages are fully flexible and variable

• there is considerable debate regarding the LRAS curve

• there are two different schools of thought

  • new classical or monetarist → more widely used

  • Keynesian AS → developed by the John Maynard Keynes

classical LRAS

• belief in the efficiency of market forces and their view that there should be the very minimum of government intervention in the allocation of resources in the economy

• in this view, the LRAS curve is perfectly inelastic or vertical at what is know as the full employment level of output

  • represents the potential output that could be produced if the economy were operating at full capacity and is annotated as Yf on a macroeconomic diagram

    • full employment does not mean zero unemployment → it means the natural level of unemployment

• asserts that the potential output is based entirely on the quantity and quality (productivity) of the factors of production and not on the price level → thus the LRAS is independent of the price level

classical LRAS graph

the price level might rise from P1 to P2, but the level of output does not change

• indicating that regardless of the price level, output will be the full employment level

Keynesian AS phases

• 1:

  • the AS curve will be perfectly elastic at low levels of economic activity.

  • producers in the economy can raise their levels of output without incurring higher average costs because of the existence of space capacity in the economy

    • there are high levels of unused factors such as unemployed labour and underutilised capital

    • should there be a need for greater output, these can be used to their fullest capacity at constant average costs

• 2:

  • as the economy approaches its potential output (Yf) and the space capacity is used up, the economy’s available factors of production become increasingly scarce

  • as producers continue to try to increase output, they will have to bid for the increasingly scarce factors

  • higher prices for the factors of production mean higher costs for the producers, and the price level will rise to compensate for the higher costs

  • shown as upwards sloping

• 3:

  • when the economy reaches its full capacity (Yf), it is impossible to increase output any further because all the factors of production are fully employed

  • this suggests that AS is perfectly inelastic and is shown in phase 3

    • this third phase aligns with the LRAS of the new classical economists

  • at this stage, output cannot be increased without an increase in the quantity or improvement in the quality (productivity) of the factors of production

shift in AS/LRAS curves

• an outward shift of a country’s AS/LRAS curve means that its productive potential has increased

  • a shift in the AS/LRAS can be likened to an outward shift of the production possibilities curve (PPC)

land: positive shift of LRAS

increase in quantity 

• land reclamation 

• increased access to supply of resources 

• discovery of new resources 

improvement in quality (productivity) 

• technological advancements → discoveries 

• fertilizers 

• irrigation 

labour: positive shift of LRAS

increase in quantity 

• increase in birth rate 

• decrease in the natural rate of unemployment 

• immigration 

improvement in quality (productivity) 

• education 

• training 

• apprenticeship programs 

capital: positive shift of LRAS

increase in quantity 

• investment 

improvement in quality (productivity) 

• technological advancements 

• research and development