Aggregate supply

Aggregate supply is the sum of all the goods and services an economy is willing and able to produce in a period of time.

Aggregate supply can be mapped by looking at how it responds to various price levels over a given period of time.

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 aggregate supply curve (AS curve, for short) 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).

AS curve

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 costs 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.

Video on aggregate supply

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 main cost, its wage costs, 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 additional costs including the cost of printing new brochures and price lists – so-called ‘menu costs’. Hence, a fall in the general price level is not automatically met by a fall in individual prices. In this case, many firms’ prices are excessive and, as a result, sales fall and firms build up stocks and cut back their output. Unexpected increases in the price level will have the opposite effect, so that some firm’s prices are ‘too low’ 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.


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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