Aggregate Supply

In the previous article, we talked about the concept of aggregate demand. In this article we will dive into the concept of aggregate supply. Aggregate supply is the total supply of all the goods and services within an economy. In other words, aggregate supply is each good’s supply added together. Economists can view the aggregate supply in two different ways. They can view it in the short run or in the long run. In basic terms, the short run spans a short period of time while the long run spans a large period of time. Since there are two ways of measuring the aggregate supply, economists separated the aggregate supply into two distinct categories, the short run aggregate supply, and the long run aggregate supply. The short run aggregate supply measures how production changes over a short time period while long run aggregate supply measures how production changes over a longer time period. What determines whether a period is short or long? Economists consider a period to be short when at least one of the factors of production (land, labor, capital, and entrepreneurship) is fixed and cannot be changed. This is because economists know that not all factors of production can be changed within such a short period of time. Once all factors of production become variable, economists will know that enough time has passed for these factors to be changeable therefore indicating the period to be long. For example, if a firm leases a portion of land, then that firm is stuck with that land until the lease expires making land the fixed input since it cannot be changed. Therefore, all actions made by the firm to increase their productions will be considered to be done in the short run as long as the land is still under the lease. Actions made after the lease expires would be considered as part of the long run since a large enough period of time has passed to make all of the factors of production variable.

Short Run Aggregate Supply

First, let’s start off by taking a look at the short run aggregate supply. Below is a graph of the short run aggregate supply:

As we can see, real GDP is labeled on the x-axis and price level is labeled on the y-axis. Recall that real GDP is measuring the total amount of goods and services produced within an economy. Therefore, this graph is measuring how production levels change across various price levels which is exactly what the aggregate supply measures. The curve on the graph is labeled “SRAS” to indicate that it is the short run aggregate supply curve. We can notice that the curve is upwards sloping demonstrating a positive relationship between the price level and real GDP. This is because as price levels increase, firms can earn more profit from the high prices and therefore are motivated to produce more goods and services which will increase the real GDP. Conversely, if price levels decrease, then firms earn less profits from production and therefore will hold back their production which will decrease the real GDP. Similar to the supply for one particular good, the entire short run aggregate supply for an economy can also change. Let’s take a look at the factors which can cause a change in the entire short run aggregate supply.

Price of Resources:

The first factor considers the price of resources. If the price of resources increases, then production becomes more costly for all firms within the economy ultimately causing the firms to reduce their production levels which causes the short run aggregate supply to decrease. Conversely, if the price of resources decreases, then production becomes cheaper which motivates the firms within the economy to produce more goods and services ultimately causing the short run aggregate supply to increase.

Taxes and Subsidies:

The second factor considers enacting taxes and subsidies. This factor depends specifically on the type of tax and subsidy and its effect. Taxes specifically aimed towards the producers of an economy will cause those producers to decrease production ultimately leading to a decrease in the short run aggregate supply. Subsidies aimed towards the producers will allow for producers to increase their production levels ultimately leading to an increase in the short run aggregate supply. It is important to note that taxes affecting the consumers of an economy does not have any effect on the short run aggregate supply as this would only affect the aggregate demand.

Productivity:

The third factor considers productivity. Certain factors such as technological advancement, or an increase in human capital cause an increase in productivity which ultimately causes an increase in the short run aggregate supply. Conversely, certain phenomena such as natural disasters or a decrease in competition could cause a decrease in productivity and ultimately a decrease in the short run aggregate supply.

Expected Future Price Changes:

The fourth factor considers producers’ expectations of how future prices will change. If producers expect that future prices will be inflated, then producers will hold off on their current productions and wait for the prices to inflate before resuming their productions in order to receive greater returns which ultimately decreases the current short run aggregate supply. Conversely, if producers expect that future prices will deflate, then producers will increase their current production levels to receive greater returns which ultimately causes the short run aggregate supply to increase. It is important to note that only future expectations of the price levels will cause a change in the short run aggregate supply. Just changes in the current price level will not shift the short run aggregate supply curve as this phenomenon would strictly be a movement along the short run aggregate supply curve.

Supply Shocks:

The fifth and final factor considers sudden changes in the availability of certain key resources. If there is a decrease in the availability of a key resource, then the short run aggregate supply will decrease labeling this phenomenon as a “negative supply shock”. Conversely, if there is an increase in the availability of a key resource, then the short run aggregate supply will increase labeling this phenomenon as a “positive supply shock”. It is important to note that supply shocks are unexpected and sudden.

Now that we have taken a look at all the factors which change the short run aggregate supply, let’s take a look at how this change is modeled graphically. First let’s graph an increase in the short run aggregate supply curve.

In this graph, the SRAS1 curve represents the initial short run aggregate supply curve while the SRAS2 curve represents the increased short run aggregate supply. We can see that at each price level, producers are willing to produce more goods and services, ultimately causing the entire supply curve to shift to the right as represented by the shift from curve SRAS1 to curve SRAS2. So, an increase in the short run aggregate supply curve is represented by a rightwards shift of the short run aggregate supply curve. Now let’s take a look at how a decrease in the short run aggregate supply curve is modeled.

In this graph, the SRAS1 curve represents the initial short run aggregate supply curve while the SRAS2 curve represents the decreased short run aggregate supply. We can see that at each price level, producers are willing to produce less goods and services, ultimately causing the entire supply curve to shift to the left as represented by the shift from curve SRAS1 to curve SRAS2. So, a decrease in the short run aggregate supply curve is represented by a leftwards shift of the short run aggregate supply curve.

Long Run Aggregate Supply

Now, let’s look at the concept of long run aggregate supply. Recall that the long run aggregate supply measures how production changes over a long period of time (a period is considered long once all factors of production are variable). In the long run, all producers in the economy are free to change all factors of production. As a result, by being given the ability to change all factors of production, all producers can maximize their productions. Therefore, we can observe that the long run aggregate supply is essentially measuring an economy’s maximum production potential, similar to what the production possibilities curve measures. To better understand this concept, let’s graph the long run aggregate supply curve.

Based on this graph, we can see that the x-axis is labeled real GDP to measure the total number of goods being produced in the economy and the y-axis is measuring the price level. The curve on the graph is labeled LRAS to represent the long run aggregate supply curve. We can notice that the long run aggregate supply curve is completely vertical. In the long run all producers have the ability to change all of their factors of production giving each producer the ability to produce at their maximum potential. Therefore, the long run aggregate supply is essentially measuring an economy’s maximum production potential. In other words, the long run aggregate supply is measuring the possible production levels if all firms in the economy produce to their maximum potential. This concept is similar to the production possibilities curve which also measures the production potential of a firm. This is why the long run aggregate supply curve is vertical. Since the long run aggregate supply is measuring an economy’s potential to produce, the price level has no effect on the real GDP. For another approach in understanding why the curve is vertical, the real GDP value which the long run aggregate supply curve gives value for the total number of goods and services able to be produced in an economy.

It is important to note that the long run aggregate supply does not change when the short run aggregate supply changes. Like the production possibilities curve, the long run aggregate supply can change only during economic growth. We will learn in future articles what causes economic growth and how it impacts the long run aggregate supply. Now that we know the concepts of aggregate demand, short run aggregate supply and long run aggregate supply, we will put all these concepts together in the next article.