The meaning of aggregate supply and its types

Aggregate supply represents the total amount of goods and services that all producers in an economy plan to supply at different price levels over a specific period. It is divided into short-run and long-run perspectives, depending on how quickly factor prices adjust to changes in demand.

Short-run aggregate supply (SRAS)

Short-run aggregate supply measures the output supplied when factor prices, such as wages and raw material costs, have not yet adjusted to shifts in aggregate demand or the overall price level.

Long-run aggregate supply (LRAS)

Long-run aggregate supply indicates the output supplied once factor prices have fully adjusted to any changes in aggregate demand or the price level.

The short-run aggregate supply curve and reasons for its shape

The short-run aggregate supply curve illustrates how the total output of an economy responds to changes in the price level in the short term. It typically slopes upwards from left to right, meaning that as the general price level increases, producers supply more goods and services.

Reasons for the positive slope of the SRAS curve

• The profit effect - When the price level rises but input costs stay the same, the difference between selling prices and production costs grows, boosting profits and encouraging higher output.
• The cost effect - As output expands, average costs can increase due to factors like overtime pay or hiring expenses, so firms need higher prices to cover these and maintain profitability.
• The misinterpretation effect - Producers might mistake a general rise in prices for increased demand for their specific products, leading them to produce more under the belief that their goods are becoming more popular.

Factors causing shifts in short-run aggregate supply

Shifts in the SRAS curve occur when changes in production costs or resource availability affect the amount firms can supply at any given price level. A rightward shift increases supply, while a leftward shift decreases it.

Key factors influencing SRAS shifts

• Changes in factor prices - An increase in wages not matched by productivity gains, or higher raw material costs, reduces SRAS and shifts the curve left.
• Changes in taxes on firms - Reductions in corporation tax or indirect taxes lower business costs, increasing SRAS and shifting the curve right.
• Changes in factor productivity or resource quality - Improvements in labour or capital efficiency allow more output at the same cost, shifting SRAS right.
• Changes in resource quantity - Short-term supply-side shocks, such as natural disasters reducing available inputs, decrease SRAS and shift the curve left.

The long-run aggregate supply curve in Keynesian and new classical views

The long-run aggregate supply curve shows the economy's maximum sustainable output once all adjustments have occurred. Different economic schools offer contrasting views on its shape and implications.

The Keynesian view of LRAS

The LRAS curve is L-shaped: perfectly elastic (horizontal) at low output levels, upward-sloping in the middle, and perfectly inelastic (vertical) at high output.

How the Keynesian LRAS curve works:

• At low output, spare capacity exists, so firms can increase production without raising prices by using underemployed resources.
• As output grows, bottlenecks emerge, such as shortages of skilled labour or materials, causing firms to bid up wages and prices, which makes the curve slope upwards.
• At full capacity, the curve becomes vertical, as the economy cannot produce more with existing resources, regardless of price changes.

The new classical view of LRAS

The LRAS curve is vertical, positioned at the economy's full-employment output level. In the long run, the economy always returns to full capacity, as markets clear and resources are fully utilised.

How the new classical LRAS curve works:

• A short-term rise in aggregate demand might boost output by using resources more intensively, shifting along the SRAS curve.
• Over time, higher demand increases costs (e.g., through wage pressures), shifting the SRAS curve left and returning output to the original LRAS level, but at a higher price level.

Causes of shifts in the long-run aggregate supply curve

Shifts in the LRAS curve reflect changes in the economy's productive capacity, agreed upon by both Keynesian and new classical economists. These shifts are driven by alterations in the quantity or quality of resources, with rightward shifts indicating growth in potential output.

Causes of increases in resource quantity

• Net immigration - An influx of working-age people expands the labour force, increasing overall supply.
• Higher retirement age - Extending the working life of the population enlarges the available workforce.
• Greater labour force participation - More groups entering the workforce, such as increased female involvement, boosts labour supply.
• Net investment - When investment in new capital exceeds depreciation, it adds to the productive capital stock.
• Resource discoveries - Finding new mineral deposits or other natural resources enhances input availability.
• Land reclamation - Projects that create usable land, like coastal developments, increase the land factor of production.

Causes of improvements in resource quality

• Education and training enhancements - Better skills development raises labour productivity by equipping workers with more effective abilities.
• Technological progress - Innovations lower production costs and expand capacity, allowing more efficient use of resources.