Aggregate supply

Aggregate supply is the second key component of demand and supply analysis. The economist's definition of aggregate supply depends upon whether the 'short run' or 'long run' is being considered.

In the short run, aggregate supply is defined as the planned output of goods and services by firms at different price levels over a period of time.

The determinants of short run aggregate supply ('AS' - or 'SRAS')

The aggregate demand-supply model maps out AD and AS in relation to the price level. How planned output responds to changes in the price level determines the gradient of the AS curve. [For convenience it is common to use 'AS' to represent short run aggregate supply, but 'SRAS' is equally acceptable]. Shifts in the position of the curve are caused by other supply variables, including production costs such as wages and raw material inputs, taxation on businesses and changes in productivity.

AS and the price level

The most convenient way to look at the price level is to use an index of price changes, such as the Consumer Price Index (CPI). The 'starting point' for this index is the base year, and the index is given the value of 100.

Changes in aggregate supply can then be measured at different price levels. This is illustrated in the following AS schedule.

AS schedule - hypothetical

In the short run, it is generally assumed that the AS curve slopes upwards.

Assuming nothing else changes, at higher prices (p=140) firms may expect to gain more revenue and profits and produce more output (at 1160). At a lower price level (p=60), firms expect lower revenue and profits, and produce less output (at 840).

The aggregate supply curve

Long run aggregate supply

Aggregate supply in the short run is determined by a number of factors which collectively effect firm’s ability and willingness to supply.

Willingness to supply

In terms of willingness, the key driver for firms is the expected level of profits that will be derived from producing at a particular price level.

The assumption is that, in the short run, the cost of factor inputs is fixed. If so, then an increase in the price level can be expected to increase firm’s revenue (if all prices are rising) and, with costs fixed in the short run, output will increase to take advantage of the increase in prices. Hence, graphically, the short run aggregate supply curve will slope upwards with respect to the price level.

Ability to supply

Firms’ ability to supply depends upon the short run availability (the quantity) and quality of factor inputs. If factors become unavailable, firms cannot produce the same quantity as before, and any increase in price may not generate the same level of response – so, for firms to be able to responds to changes in the price level there must be an ability to supply that accompanies it. This relates to the firm’s price elasticity of supply. Under this circumstance, the aggregate supply curve will be steeper.

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Why do aggregate supply curves slope upwards?

There are three main theories of the upward sloping AS curve:

Wages are ‘sticky’

‘Sticky wage’ theory suggests that a firm’s wages are slow to adjust because most nominal wages are fixed, contractually, for a period of time. Nominal wages this year are based on last year’s prices. Hence, if prices fall below what is expected, real wages rise as nominal wages cannot be reduced by firms in the short run. The rise in real wages represents a cost to firms, and they reduce output in response.

AS curve

Prices are ‘sticky’

This theory suggests that it is often too costly for firms to keep changing price following an increase in costs. For example, increasing prices means printing new brochures and price lists, and requires using management time and effort to agree and set the new prices.  Hence, a fall in the general price level is not automatically met by a fall in individual prices by all firms. Hence, with a fall in the general price level, firms may not adjust their prices with the result that sales fall and firms build up stocks. To deal with this, firms will cut back their output. Unexpected increases in the price level will have the opposite effect, so that some firm’s prices remain relatively low (until they are adjusted upwards) and sales rise, leading to increased output.

Wrong perceptions

This explanation focuses on the view that firms may believe that falling prices are affecting their own firm and not necessarily the rest of the economy. They, wrongly, believe that their prices are falling relative to other firms, and because of this, they reduce production. Of course, other prices may be falling, including the prices of their raw materials, and the prices of competitors. But they ‘wrongly’ readjust their output based on their misperception. Conversely, if prices rise in general, firms may believe that prices in their own market are rising and this encourages them to increase output.

Long run aggregate supply

In microeconomics, the long run refers to a situation when producers can increase the output of their goods and services without any short-run constraints in terms of fixed factors. In the long run all factors of production can be increased, including capital assets.

However, in terms of macroeconomic analysis, aggregate supply in the long run refers to how much real output - in terms of its monetary value - can be produced using all of the economy's scarce resources - labour, enterprise, capital, land and other natural resources.

In measuring aggregate supply in the long run it is assumed that the quantity and quality of output is not determined by the price level, but by other determinants including the quantity of factors, how efficiently they are used, and the application of new technology.

The incentive to supply is driven by the pursuit of profits, and changes in the general price level are assumed to have no impact on profits in the long run.

The long run aggregate supply curve

The long run aggregate supply curve (or LRAS curve) is assumed to be a vertical curve at the economy’s output capacity - which can be referred to in several ways, including 'full employment' capacity, the 'natural' level of output, and the 'normal capacity' level of output.

The key point is that the position of the LRAS curve is not determined by the price level, but by factors that affect the capacity of firms.

Determinants of LRAS

Application of technology

New technology increases the efficiency with which scarce resources are used and the productivity of the factors of production.

Economic incentives

The supply-side of an economy tends to work best when there are strong incentives to encourage existing factor owners to supply more, or improve their ability to supply. The ability to derive profits is a key incentive to the entrepreneur. Profits are also an incentive to encourage new entrepreneurs to develop new products. Lower business taxes can also act an incentive as firm's can retain more of their revenue.

Wage incentives are also significant, especially when they are connected to productivity improvements. However, linking wage increases to productivity may be resisted by trade unions who see such wage bargaining as simply a way to suppress wages.

Productivity

The productivity of labour [output per hour worked] is a very significant variable when considering a country's capacity to produce.

Productivity affects both the short and long run aggregate supply of a country. In the short run productivity improvements can reduce production costs and in the long run improvements in productivity increase capacity from existing factor inputs.

Mobility of factors and flexibility of labour

Labour mobility - both in terms of geographical and occupational mobility - has a significant bearing on an economy's productive capacity. If labour is occupationally mobile, there will be a better match between the skills supplied by labour and the skilled required by firms. Similarly, geographical mobility means that labour is used more effectively, with less likelihood of being unemployed or underemployed.

Flexibility of labour includes mobility, but also refers to whether workers are flexible in terms of the hours they work, and the skills they have. If workers are inflexible, it may mean that they do not participate in the labour market at all, and remain unemployed. The rise of part-time and flexi-work has meant more participation in the labour market, and hence there is more potential output from any given quantity of labour.

Supply of capital

The supply of capital provides the resources by which firms can expand. An effective capital market is very important for productive potential to be maintained and increased. With an efficient stock exchange, holders of shares can regain their liquidity by selling their shares, and, therefore are more likely to purchase shares in the first place. This encourages a flow of funds into the capital market.

Effectiveness of the banking sector

Similarly, it is essential to have an effectively functioning banking sector, with both commercial and investment banks willing to lend to firms so that they can expand or simply to ensure liquidity in the system.

The transport and communications infrastructure

The total amount that an economy can produce in the long run is dependent on the ability to mobilise resources and distribute them to where they are needed. While infrastructure improvements take time to plan and build, there is little doubt that they have a considerable impact on supply.

Similarly, production and commerce requires an effective communications infrastructure. A country's ability to develop depends on an effective transport and communications network.

The LRAS curve

In the long-run, and assuming normal levels of inflation – somewhere between 2 and 5% - the price level has little bearing on output.

However, the quantity and quality of factors, including 'human capital', the use of technology, and the productivity of factors, do have an influence on the capacity of the economy, and therefore on the position of the LRAS curve.

Although vertical, the LRAS can shift if productive potential changes, such as when new technology is introduced, or a change in any determinant listed above.

Long run aggregate supply

It is assumed that the LRAS curve is influenced more by supply-side policy than fiscal or monetary policy.


Video on long run aggregate supply

The Keynesian Aggregate Supply Curve

The Keynesian AS curve has two distinct elements to it. A vertical section which is equivalent to the vertical curve of the LRAS curve, as shown above, and a horizontal section covering the output range from zero up to the vertical portion.

This version derives from the proposition by Keynes that up to a certain output increases in AD would cause the economy to expand without any inflationary pressure (over the range zero to YN). Any point between zero and YN is defined as a deflationary gap as the economy is operating below its capacity, at YN. The gap is shown as v - w.

However, if AD increases beyond YN, the result is inflation, with an inflationary gap shown as m - k.

Long run aggregate supply

Following the work of AW Phillips and taking into account the Phillips curve, an adjusted Keynesian LRAS would show an intermediate range, where both inflation and unemployment could occur at the same time - shown at point U in the adjusted diagram.

Does money and monetary policy affect long run supply?

It has been a fairly long held belief that 'money is neutral' in its effect - the argument goes that changes in the money supply affect the price level, and because changes in the price level do not affect long run supply, then money and monetary policy have little bearing on the long run aggregate supply curve.

Long run aggregate supply

However, this position can be challenged - changes in monetary conditions can influence investment decisions, which can then increase an economy's capacity to produce. Research by Òscar et al 1 also indicates that monetary shocks can have long lasting effects on real national output.


Aggregate demand

More on aggregate demand and the AD curve.

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Fiscal policy

How can fiscal policy influence aggregate demand?

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Supply-side policy

Is supply-side policy effective at controlling inflation?

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