Aggregate Supply (AS): Your Ultimate Study Guide!

Hey everyone! Welcome to your go-to notes for Aggregate Supply (AS). Ever wonder why prices for everything seem to go up sometimes, or why the economy can produce more in some years than others? Aggregate Supply is a huge piece of that puzzle!

In this chapter, we're going to look at the 'production' side of the whole economy. We'll break down:

  • What Aggregate Supply actually is.
  • The difference between producing in the short run (SRAS) and the long run (LRAS).
  • What causes the whole economy's production capacity to change.

Don't worry if this sounds complicated. We'll use simple language and everyday examples to make it super clear. Let's get started!


What is Aggregate Supply (AS)?

First things first, what are we talking about? In simple terms:

Aggregate Supply (AS) is the total quantity of goods and services that all firms in an economy are willing and able to produce and sell at a given price level, over a period of time.

Think of it like the supply curve you learned about for a single market (like apples), but this is for everything produced in the entire economy – from iPhones to haircuts to construction services.

The key idea in this topic is that the economy behaves differently in the short run compared to the long run. So, we have two different AS curves to study.

1. Short-Run Aggregate Supply (SRAS)

What is it?

The Short-Run Aggregate Supply (SRAS) curve shows the relationship between the general price level and the quantity of real output (real GDP) firms are willing to produce, assuming that some input prices are fixed or "sticky".

Why is the SRAS Curve Upward Sloping?

The main reason is what economists call imperfect adjustment of input prices. The most important "sticky" price is usually wages.

Analogy: The Bakery Story
Imagine you own a bakery. You've signed a one-year contract to pay your bakers a fixed salary. This salary is your main input cost.

Let's break it down step-by-step:

  1. Wages are 'Sticky': Your bakers' salaries are fixed for the year because of their contracts. They don't change day-to-day.
  2. Output Prices Rise: Now, imagine a sudden increase in demand for bread across the city. The price you can sell your bread for (the output price) goes up.
  3. Profit Margin Increases: Your revenue from selling bread is higher, but your biggest cost (wages) has stayed the same. This means your profit on each loaf of bread is now bigger!
  4. Incentive to Produce More: As a business owner, what do you do when profits are high? You produce more! You might ask your bakers to work overtime to bake and sell as much bread as possible.

This is what happens across the whole economy. When the general price level increases, but wages and other input costs are sticky, firms become more profitable and have an incentive to increase their output. This gives us an upward-sloping SRAS curve.

Quick Review Box

SRAS is upward sloping because:

  • In the short run, input costs (like wages) are fixed or "sticky".
  • When the overall price level rises, firms' revenues increase but their costs do not (or rise more slowly).
  • This leads to higher profits, which incentivizes firms to produce more output.
  • Therefore, a higher price level leads to a higher quantity of aggregate output supplied.

What Shifts the SRAS Curve?

A shift in the SRAS curve means that at every price level, firms are now willing to produce a different amount of output. Think of SRAS shifters as things that change the cost of production for many firms in the economy.

Memory Aid: A change in production costs shifts SRAS.
- If costs go DOWN, firms can produce more at each price level -> SRAS shifts RIGHT.
- If costs go UP, firms will produce less at each price level -> SRAS shifts LEFT.

Key Shifters of SRAS:
1. Cost Shocks (Changes in Input/Factor Prices)

These are sudden changes in the prices of key resources.

  • Example (Shift Left): A huge increase in the global price of oil makes transportation and energy more expensive for almost all businesses. Production costs rise, and the SRAS curve shifts to the left.
  • Example (Shift Right): A discovery of a new, cheaper way to produce electricity would lower energy costs for firms. Production costs fall, and the SRAS curve shifts to the right.
2. Government Policies

Government actions can directly affect firms' costs.

  • Taxes: An increase in company profit tax or sales tax acts as an extra cost for businesses. This causes the SRAS to shift left.
  • Subsidies: If the government gives subsidies to firms (e.g., for hiring new workers or for green technology), it lowers their production costs. This causes the SRAS to shift right.
  • Regulations: Stricter environmental or safety regulations can increase the cost of compliance for firms, causing the SRAS to shift left.
3. Other Factors (like Supply Shocks)

These are unexpected events that affect the ability to produce.

  • Example (Shift Left): A widespread natural disaster (like a typhoon) that damages factories and disrupts transport links would reduce the economy's ability to produce goods, shifting SRAS to the left.
  • Example (Shift Right): Exceptionally good weather leading to a record-breaking agricultural harvest would increase output, shifting SRAS to the right.
Common Mistake Alert!

A change in the general price level causes a movement ALONG the SRAS curve. It does NOT shift the curve. A shift is only caused by a change in one of the factors above (like production costs or government policy).

Key Takeaway for SRAS

The SRAS curve is upward-sloping because input prices like wages are sticky in the short term. The curve shifts when there are economy-wide changes in the cost of production.

2. Long-Run Aggregate Supply (LRAS)

What is it?

The Long-Run Aggregate Supply (LRAS) curve shows the relationship between the price level and real output when all prices (both input and output prices) are fully flexible and have adjusted.

In the long run, the economy's production is determined by its resources and technology, not the price level. This level of output is known as potential output or full-employment output (Yf).

Why is the LRAS Curve Vertical?

There are two key reasons why the LRAS is a vertical line.

Reason 1: All Prices are Fully Flexible
In the long run, those "sticky" wages from our bakery story are no longer sticky. Contracts can be renegotiated. If the price of bread doubles and stays high, your bakers will eventually demand double the salary.

  • If the general price level doubles...
  • ...wages and all other input costs will also double.
  • This means a firm's profit margin remains the same.
Since profits don't change, firms have no incentive to change their level of production. Therefore, a change in the price level has no effect on the quantity of output supplied in the long run.

Reason 2: The Economy has a Capacity Constraint
The LRAS represents the maximum sustainable output an economy can produce. This 'potential' depends on its available factors of production, not the price tags on goods.

Analogy: The Factory's Maximum Capacity
Think of the entire economy as one giant factory. In the long run, the total amount this factory can produce depends on:

  • The number and skill of its workers (labour)
  • The number of machines and buildings it has (capital)
  • The amount of raw materials available (natural resources)
  • How efficiently it can combine these things (technology)
Putting higher price tags on the factory's products doesn't magically create more machines or workers. The factory's potential output is fixed by its resources. That's why the LRAS is vertical.

What Shifts the LRAS Curve?

Since the LRAS is all about potential, a shift in the LRAS means the economy's fundamental productive capacity has changed. This is what we call economic growth!

Memory Aid: LRAS shifts when there's a change in the quantity or quality of the factors of production.

Key Shifters of LRAS:
1. Changes in Factor Endowments
  • Labour: An increase in the size of the workforce (e.g., from immigration) or an improvement in the skills of the workforce (e.g., through better education and training) will shift LRAS to the right.
  • Capital: More investment in physical capital (more factories, machines, roads) or human capital (knowledge and skills) increases productivity and shifts LRAS to the right.
  • Natural Resources: Discovering new reserves of oil or minerals, or developing ways to use existing resources better, can shift LRAS to the right.
2. Technological Changes
  • Technology: This is a huge one! Inventions and innovations (like the internet, automation, or more efficient manufacturing processes) allow us to produce more output with the same amount of resources. This increases productivity and shifts LRAS to the right.
Did You Know?

When something shifts the LRAS curve to the right (like a technological breakthrough), it almost always shifts the SRAS curve to the right as well. Why? Because better technology not only increases our potential (LRAS) but also lowers our production costs at every price level (SRAS).

Key Takeaway for LRAS

The LRAS curve is vertical at the level of potential (full-employment) output. It's vertical because in the long run, all prices are flexible, so the price level doesn't affect output. The LRAS curve only shifts when there is a change in the economy's fundamental productive capacity (its resources or technology).


Final Summary: SRAS vs. LRAS

Let's put it all together in a simple table. This is perfect for revision!

| Feature | Short-Run Aggregate Supply (SRAS) | Long-Run Aggregate Supply (LRAS) | | :--- | :--- | :--- | | Shape | Upward sloping | Vertical | | Why? | Input prices (especially wages) are "sticky". Higher output prices mean higher profits, so firms produce more. | All prices are fully flexible. Changes in the price level do not affect profits or the incentive to produce. | | Represents | The current production level at sticky input prices. | The economy's potential or full-employment output (Yf). | | What Shifts It? | Changes in the cost of production (e.g., oil prices, taxes, subsidies, supply shocks). | Changes in the quantity/quality of resources or technology (e.g., more labour, new machines, innovation). |

And that's it for Aggregate Supply! Understanding the difference between the short run and the long run is crucial for mastering macroeconomics. Keep reviewing these concepts, and you'll be an expert in no time!