Fundamentals of Aggregate Supply: Long-Run and Short-Run Dynamics

Overview of Aggregate Supply (AS) Curves

  • Aggregate Supply represents the total quantity of goods and services produced and sold within an economy at various price levels.

  • There are two distinct types of aggregate supply curves, which are easily distinguished by their shapes:

    • Long Run Aggregate Supply (LRAS): Characterized by a vertical line.

    • Short Run Aggregate Supply (SRAS): Characterized by an upward-sloping curve.

The Long Run Aggregate Supply (LRAS) Curve

  • Vertical Shape: The LRASLRAS is a perfectly vertical line in the Macroeconomic diagram (where the y-axis is the price level and the x-axis is real GDP).

  • Independence from Price Level: The verticality of the LRASLRAS indicates that changes in the price level do not affect the total level of output in the long run. Regardless of where the price level sits, the level of output remains constant at a specific point labeled as Q∗Q^*.

  • The Concept of Q∗Q^*: This quantity represents the production level toward which the economy gravitates in the long run. It is referred to by several synonymous terms:

    • Potential GDP.

    • Full employment output.

    • Natural rate of employment/output.

  • Defining Potential GDP: While some textbooks define this as "productive capacity," this can be misleading as "capacity" implies an absolute maximum. In economic terms, Potential GDP is the output level produced when the nation is operating at its typical or normal level.

    • Normal Operations: This refers to businesses being open their regular hours (e.g., 8:00 AM to 5:00 PM, five days a week) and employing a normal amount of people.

    • Natural Rate of Unemployment: At Potential GDP, the only people unemployed are those experiencing frictional unemployment (looking for a better fit) or structural unemployment (mismatch of skills). This level of output corresponds with the normal rate of unemployment.

    • Exceeding Capacity: It is possible for an economy to produce more than its potential GDP. This occurs by working longer hours, opening on weekends, or having more people employed than typical. For instance, prior to recent layoffs of 1010 million or more due to the virus, the economy had significantly more people working than is typical, allowing output to push past the normal $Q^*$ level.

  • Classical Theory: The principle that changes in the price level do not affect output in the long run is a core tenet of Classical Theory. In this view, output is determined by real variables (factors of production) rather than nominal variables like price levels.

The Short Run Aggregate Supply (SRAS) Curve

  • Upward Sloping Nature: Unlike the long-run curve, the SRASSRAS is upward sloping. This illustrates a positive relationship between the price level and the quantity of goods and services supplied.

    • As Price Level (PLPL) rises, the quantity of real GDP supplied rises.

    • As Price Level (PLPL) falls, the quantity of real GDP supplied falls.

  • Underlying Rationale: The movement along the curve is driven by the fact that if a firm can sell its product for a higher price while costs remain relatively stable, it has an incentive to produce more.

Theories Explaining the Upward Slope of SRAS

Two primary theories explain why the quantity supplied responds positively to price level changes in the short run. Both theories often rely on the assumption of unexpected price level changes.

  • Sticky Wage Theory:

    • Definition: Wages are often slow to adjust to changing economic conditions because of long-term contracts (such as union agreements or annual salary settings).

    • Mechanism of a Price Rise: If the price level (PLPL) rises unexpectedly but wages remain "stuck" (slow to respond), the real cost of labor to the firm decreases in relative terms.

      • Hypothetical Scenario: A firm sells units for $100\$100 and pays a worker $20\$20 per hour, a 55 to 11 ratio. If the price of the unit rises to $120\$120 but the wage stays at $20\$20, the ratio becomes 66 to 11. The worker is now more valuable to the firm in relative terms.

    • Outcome: Because production and employment become more profitable for the firm, they hire more workers and increase the quantity of goods and services supplied.

    • Mechanism of a Price Drop: If the price level falls while wages are stuck, firms pay more in relative terms than intended (e.g., the ratio drops from 55 to 11 down to 44 to 11). Production becomes less profitable, leading to a decrease in the quantity supplied.

  • Sticky Price Theory:

    • Definition: The prices of some goods and services are slow to adjust due to menu costs, which are the literal costs associated with changing prices.

    • Examples of Menu Costs: For most restaurants, reprinting menus is a high expense. While gas stations use digital boards or suction cups to change prices instantly, a pizza place might use tape or pen to cover old prices because reprinting is not worth the cost.

    • Mechanism of a Price Rise: If the general price level rises but a firm keeps its prices stuck (to avoid menu costs), that firm now has lower-than-desired prices compared to competitors.

    • Outcome: Consumers flock to the firm with the relatively lower prices, leading to an increase in sales. To meet this increased demand, the firm increases its output, which increases the total quantity of goods and services supplied.

    • Mechanism of a Price Drop: If the general price level falls but a firm's prices remain stuck, that firm now has higher-than-desired prices. Sales will fall as consumers go elsewhere, and the firm will subsequently reduce its quantity of goods and services supplied.

Shift Factors Affecting Short-Run Aggregate Supply (SRAS)

Shifts in the SRASSRAS curve are caused by factors other than the current price level. These are primarily changes in the factors of production.

Factors Shifting SRAS to the Left (Decreases)

  • Labor and Capital: A decrease in the labor force or a reduction in capital (equipment, structures, machinery).

  • Technological Change / Productivity: A decrease in productivity or a negative technological change.

  • Expected Future Price Level: If workers and firms expect the price level to rise in the future, they will negotiate higher wages and set higher prices now, which shifts the current SRASSRAS to the left.

  • Natural Resources: An unexpected increase in the price of a natural resource. Oil is a significant example because it is a primary input for many goods.

  • Adjustment to Underestimation: An adjustment made by workers and firms who previously underestimated the price level and are now raising wages/prices to compensate.

Factors Shifting SRAS to the Right (Increases)

  • Labor and Capital: An increase in the labor force or an increase in the amount of available capital.

  • Technological Change / Productivity: Improvements in technology or an increase in productivity.

  • Expected Future Price Level: If the expected future price level falls, it shifts the current SRASSRAS curve to the right.

  • Natural Resources: An unexpected fall in the price of a natural resource (e.g., a drop in oil prices).

  • Adjustment to Overestimation: An adjustment made by workers and firms who previously overestimated the price level, leading to lower prices and wages in the current period.

Summary of Movement vs. Shift

  • Movement along the curve: Caused by a change in the actual price level (often treated as an unexpected change in the short run).

  • Shift of the curve: Caused by a change in the expected price level or changes in the fundamental factors of production (Labor, Capital, Technology, Natural Resources).